July 2001

Equitable send FSA an outline of a paper entitled ‘The Business Case for the Section 425 Scheme’ for FSA comment. The content of the paper is set out under six main headings:

1. Problem
2. Options
3. Appraisal of the options
4. Proposed Solutions
5. Details
6. Appendix

[09:47] Line Manager E circulates the document within FSA and recipients comment upon it.

[12:16] The Head of Life Insurance says that the list of issues looked comprehensive and suggests that the possibility that FSA might produce an information sheet could be flagged under a heading in the ‘Details’ section entitled ‘What will policyholders receive?’.

[14:59] The Head of Actuarial Support says that he remained unconvinced by the steps set out in the ‘Details’ section of the paper, which included the further headings:

5.1 How do we achieve a Section 425 Compromise Scheme?

5.2 Why is the value discounted to [£]1.37 billion?

5.3 Why are we allocating the [£]1.37 billion in the proposed way?

5.4 Why did we use these factors and not others?

5.5 The scheme

5.6 The scheme procedure

5.7 What will policyholders receive?

5.8 What is the role of the independent actuary?

5.9 What will happen if the scheme is effective?

However, the Head of Actuarial Support recognises that this would be an issue for lawyers to resolve.

[15:54] Legal Adviser D raises a number of points, including that made by Counsel on 27/06/2001 [14:30] that the use of a section 425 scheme for a solvent insurance company was unusual and ‘arguably a questionable use of s.425 at all if the Equitable is solvent’. The Legal Adviser explains that the Court ‘will be required to be satisfied that there is no better alternative to the proposed s.425 compromise since GAR policyholders are being asked to give up valuable legal rights. Unpalatable though it might be for the Equitable it will need to have a section in paragraph 1.2 “What is the problem?” a heading such as Unable to maintain Required Solvency Margin and give an indication of how likely and/or how soon it might breach [that margin] without the compromise being approved’. Legal Adviser D also says that, as Counsel had advised, the proposed scheme should first calculate the value of GAR rights and then decide on the amount to be allocated, rather than the other way round.

[16:10] The Insolvency Practitioner advises that there were a reasonable number of solvent section 425 schemes and that he did not think this was questionable as ‘after all, it is a Companies Act procedure not an Insolvency Act one’. The Insolvency Practitioner also comments that he ‘[does] think that there is a question whether the scheme should provide for the run-off of the fund on an insolvent basis should the solvency decline further (increase in mis-selling claims or stock market falls). ie it would be drafted with [a named company] type provisions which kick in when it becomes insolvent in someone’s view. I had assumed that the scheme would not have such provisions because it would be scare-mongering, but perhaps the board should explicitly consider this option’.

[16:43] The Insolvency Practitioner provides some further comments on the detail of the outline paper, including that Equitable could provide policyholders with updated financial statements.

[19:56] The Director of Insurance agrees with his view on the use of such a scheme by a solvent company.

FSA’s Line Manager E seeks advice from the Director of Insurance on how to acknowledge Equitable’s former auditors’ letter of 29/06/2001 [19:40]. [13:59] Line Manager E later suggests some wording, which includes the following:

I confirm that the Society had already been in touch with the FSA about the matters raised in your letter. As you say, it has been agreed that the Appointed Actuary’s certificate, which forms part of the regulatory returns, would disclose the matters in terms that are acceptable to the FSA. On the basis that [Equitable’s auditors] have been able to report on the statutory returns for the period ended 31 December 2001, we assume that you also find disclosure in those terms acceptable as the Society’s auditors.

The Line Manager says that the wording was deliberately cautious about what was said in Equitable’s Appointed Actuary’s certificate as FSA were yet to locate the Society’s returns among those received.

FSA’s Director of Insurance responds to the Insolvency Practitioner’s paper on the tests that FSA ought to apply to the compromise scheme (see 29/06/2001 [10:19]). The Director of Insurance says that the paper was helpful, particularly in relation to the possible approaches to quantification. The Director continues: ‘However my instinct is that the hurdles which the FSA will wish to see cleared are a little higher than you suggest, given our responsibilities to consider whether “sound and prudent” is met’. The Director of Insurance suggests meeting to discuss this test before they considered the actual proposals in detail.

[13:08] Scrutinising Actuary F provides some thoughts in advance of a meeting the following day to consider the issue. The Scrutinising Actuary says:

One of the key issues is whether it is acceptable for any individual to be any worse off under the Scheme.

Notes of our meeting with Counsel last Wednesday are awaited, but this was a topic we discussed at length. My understanding is that Counsel’s view was that, since the company is not insolvent, no GAR policyholder should be offered less than the value of his/her GAR rights. This is particularly important for those policyholders just coming up to retirement, who in the absence of the Scheme would have the option to exercise their GAR in full.

Counsel’s view appeared to be that for those about to retire the value of these rights should not be influenced by the behaviour of other policyholders, i.e. the assumed take-up rate. However, for those retiring in 30 years’ time, it may be acceptable to incorporate the take-up rate in the calculations. This suggests the need for an age-related scale.

The value of these GAR rights changes as interest rates move and the shape of the yield curve changes. I would suggest an appropriate way of determining these rights at a particular point in time is to use financial option theory – as used by those who price derivatives. We asked Equitable whether they had considered this as one of our long list of questions on the S425 Actuarial Report ([Line Manager E’s] letter of 14 June). Their answer was that they had not considered this yet, but they were “looking at what can be done”. Time is running out.

[13:41] Line Manager E says that FSA: ‘need to be clear of the basis and reasons for our acting here. It seems to me that we have general powers and we have the ability to put a case before the court at the hearing. However, as [the Insolvency Practitioner] has pointed out, we must not forget that the policyholders concerned are being given the opportunity to vote on whether or not they are prepared to accept a deal. If they do so willingly, then it is not, I think, for us to intervene provided we can be clear that the proposals are not totally unreasonable and that we believe that they have voted on the basis of a reasonable understanding of what is on offer. I think our role is to provide suitable safeguards and ensure that the basis on which the scheme is developed is sound, and that people are not asked to sign up to something that is demonstrably unfair or unreasonable’.

[15:26] The Head of Actuarial Support also comments on the Insolvency Practitioner’s note, saying that he would: ‘doubt the practicality of some of this. In particular, I cannot see how you can provide meaningful information to inform a policyholder about the choice he should make through a single “policy value”. Similarly, quantification of “investment freedom” is highly speculative and I would be very dubious about making some arbitrary assumption for this purpose about (a) the future investment policy and (b) the outperformance of equities over gifts. The latter will be very dependent on both the term of the policy and actual market events that may transpire’.

The Director of GCD provides Chief Counsel A and Counsel with his views in response to Chief Counsel A’s note to Counsel of 29/06/2001 [15:59/16:00]. The Director of GCD says:

I think they need to consider whether a package along the following lines would be sustainable:

• make clear this needed for reasons actually needed
• point out that existing approach misleading – as per [the Baird Report]
• ensure no loss of transparency by establishing a clear policy for future determination of bonus levels
• demonstrate fairness by making clear will apply to GAR + non GAR alike
• confirm that as per [House of Lords], once declared, terminal bonus benefits from GAR
• make clear that cannot affect shares in accommodation, which will abate rateably
• note that financial condition is relevant to compromise
• make a virtue of MVA reduction.

FSA meet to discuss the criteria by which FSA should judge the compromise scheme.

[15:53] Following the meeting, the Director of Insurance sends Chief Counsel A (and others) a note which records that they had agreed to seek Counsel’s advice on the issue and which sets out the ‘policy instructions’ they had discussed.

[17:50] Following the meeting, Scrutinising Actuary F confirms the two issues on which actuarial input was to be sought and discusses how FSA could undertake the necessary work. The first of these is to ‘verify that FSA are satisfied with Equitable’s statement that their statutory solvency position would improve by £1.3bn. should a Scheme of comparable cost to that currently proposed be implemented’.

The Actuary sets out a suggested approach that FSA could take to this work:

1.We understand that the figure of £1.3bn. represents the difference between (a) the GAR reserve held in the regulatory Returns (after reinsurance) and that part of the resilience reserve which relates to the GAR liabilities, and (b) the value to be ascribed in the regulatory Returns to the uplift to be granted to the GAR policyholders (plus any associated resilience reserve).

2.We expect that the Society will already have performed their own calculations which have come to the conclusion above. To gain full comfort as to the reliability of these results, we recommend that it would be necessary to undertake an audit of this work. This would entail sending a team of actuaries to the Society’s Offices to review the calculations which have been done, the systems which were used, and the data which was processed. This approach allows a more in-depth analysis than can be achieved by our reviewing a Report from the Society on the subject – although they could no doubt furnish us with this.

3.In particular, the audit would need to pay attention to the following aspects:

• a breakdown by major groups of the Society’s business to which GAR’s attach. This would show the amount of the benefits under these policies, the amount of the GAR’s attaching, selected retirement dates under the contracts, and the liabilities in respect of both the main benefits and the attaching GAR’s;
• details of how the above liabilities would alter as a result of the Scheme – from the release of the GAR reserve & the addition of the uplift on those same policies;
• a sensitivity analysis showing how the results vary (primarily) under different economic conditions, but also on different assumptions re future mortality;
• the results of the resilience tests, how the most onerous resilience scenario was determined, and the amount of the resilience reserve thereby held. The impact of buying out the GAR benefits on the resilience tests. Note that the resilience tests are applied to the total portfolio of the company – a possible consequence of removing the GAR liabilities is that a different resilience test becomes the most onerous.

Scrutinising Actuary F then explains that the impact of this would be:

The benefit of the release of £1.3bn. from the statutory liabilities is an immediate improvement in the free assets of the Society. This permits the adoption of a higher equity backing ratio (EBR) for the with profits business. The Society have reduced this EBR post-[House of Lords] from c.72% to c.61% of with profits liabilities. They would be unlikely to want to increase it beyond 75%. Even were they to do this, assuming equities out-perform gilts by 3% p.a. (a typical long term assumption), the impact on the investment return of the fund would be an increase of 14% of 3%, i.e. 0.42%, or say 0.5% p.a. This is only a modest improvement on the current position, especially for those close to retirement. There is however a reduced risk of statutory insolvency going forwards. Additionally, of course, the fund would benefit from the further injection of £250m.-£500m. from the Halifax – this though is to be used to benefit investment performance, rather than being credited directly to policy values.

On the second issue that FSA ‘assess the value of the GAR rights enjoyed by GAR policyholders (whether individually or collectively). What is the “market value” of these rights?’, the Actuary suggest that FSA’s approach should be that:

… these rights be valued by the use of financial option theory, as used in derivative pricing. However, in addition to the economic elements of the calculations (e.g. the assumed 15 year gilt yield 10 years hence), other assumptions would need to be made regarding e.g. the dates on which policyholders choose to exercise their options, the extent to which they would pay future premiums into their contracts, together with actuarial/demographic assumptions regarding the future mortality experience, and so on. The situation is effectively the opposite of that in [a friendly society], who you will recall last year invested in a range of swaptions to hedge their GAO liabilities over the next 30 years. Here the GAR policyholders are being asked to swap their future (variable) rights for a fixed amount.

Scrutinising Actuary F says that, in view of the ‘complex and specialist nature of this work’, he had passed it to another actuary at FSA.

[19:06] After receiving comments on the note, the Director of Insurance asks Line Manager E to translate the material into a draft letter to Equitable, setting out FSA’s views on the relevant criteria.

FSA’s Head of Actuarial Support replies to Scrutinising Actuary F’s note, advising:

The audit of the resilience reserve suggested here would be very resource intensive and I am not sure of the value that we would obtain from this very detailed examination of this one point. In particular, the release of reserve will improve the statutory solvency position, but it does not affect either the Companies Act solvency position or the aggregate policy values.

We also need to be very cautious about assuming that increased investment in equities will necessarily provide greater value for policyholders (even if we were confident that they would change their investment policy in this fashion). This increased return is in effect the equity risk premium that is “earned” to cover the risk that equities could fall significantly in value. This risk will though be borne entirely by the members of the society. Moreover, many economists would question whether such a “risk premium” exists at all. Accordingly, I would not place any long-term value to policyholders on this potential change in investment policy. In the short term (which will affect those near retirement), the level of investment returns on equities relative to fixed-interest must be quite uncertain.

Regarding the value of the GAR options, we have already requested [Equitable’s Appointed Actuary] to provide some results using financial option theory. When we receive these, we shall need to review this information with the assistance of the Traded Investment team at FSA.

[12:42] FSA’s Insolvency Practitioner adds that he is ‘very concerned about whether the Equitable can meet the tests if we disregard improved investment returns’. The Insolvency Practitioner explains:

As I understand [the Director of Insurance’s] first test for GAR policyholders (in aggregate, as a class, are they better off under the scheme than without it?), the calculation we are proposing is:

If I understand [the Head of Actuarial Support’s] first paragraph correctly, I agree with it. The reserving requirements in the FSA returns are irrelevant to policyholders – it does not result in a penny more being paid to policyholders in aggregate. It might allow higher terminal bonuses to be paid to those retiring soon but at the expense of paying lower terminal bonuses to those retiring later unless investment returns also improve to enable later terminal bonuses to be increased.

If the improved investment return for the Society as a whole amounts to more than £1.1bn (on the above figures) then the scheme works, otherwise it will not pass our tests. Without improved investment returns being taken into account the scope to increase the transfer value is limited to about £1.7bn because of the second test (are non-GAR’s better off with the scheme than without):

One final thought on how the market value of the GAR’s should be calculated. These policies are not transferable. There is no open market on which they can be sold or priced. Should therefore the market value be the actual value which could be obtained if GAR’s exercised all their rights now – ie a liquidation value?

[16:06] The Director of Insurance agrees with the Insolvency Practitioner and, while noting the Head of Actuarial Support’s concerns, says that he was ‘still firmly of the view that we must be able to assess, and the Society must be able to demonstrate, the fairness of the exchanges which will be involved in the s425 scheme’. The Director of Insurance continues:

Thus we need something which will give us some measure of the “GAR Value” and the value of the positive gains and the negatives avoided through the scheme.

Against that background, and the background of what we and the company have said about the disbenefits of an unstable fund in which GARs and non GARs are still opposed, and the investment constraints that that imposes, then we surely must believe that resolving that uncertainty is beneficial. If that is so we must find some sort of proxy for the value of that benefit.

But I am, of course, open to suggestions on how we might approach that assessment, recognising always that we will need to reach some sort of publicly defensible view (and methodology) very quickly. In all the circumstances I don’t think that cash resource constraints ought to deter us from action which, while it might not strictly add value, could be essential if we are to be able credibly to claim that we have reached a wholly objective and independent view.

[18:26] FSA’s Head of Actuarial Support responds that he thinks:

… what we are really looking for here is some measure of the reduced probability of insolvency ensuing (as a result of the scheme) to which we shall give some further thought. This will though be quite different from the £1.3Bn resilience test figure to which you referred earlier. A detailed audit of this single figure is not going to help us to resolve that issue, but I shall try to think further about where we could focus our efforts.

As I indicated earlier, I would be very sceptical about placing some assumed value on the ability to invest more heavily in equities. Indeed, the latest informal comments suggest that they are likely to have to move more heavily towards fixed-interest in any event.

The Head of Actuarial Support adds that FSA had also discussed briefly with Equitable’s Appointed Actuary the use of financial options. He reports that the Appointed Actuary ‘has discussed this with his firm’s experts and they are of the view that this is not likely to give us much more insight, given that these options are now so far into the money’.

FSA meet Equitable to discuss the outcome of Equitable’s Board meeting the previous day and to get an update on ‘a range of issues related to the current situation’. FSA make a note of the meeting.

Equitable Board meeting

Equitable report that their Board had recognised that there was no easy way to implement the change in bonus policy which would provide financial stability to the with-profits fund. Equitable say that they had identified two realistic options: reducing final bonus or reducing total policy values, and had decided on the latter. Equitable add that there would be serious practical difficulties in implementing the decision.

Equitable’s Chief Executive says that, following the Board meeting he had met with Counsel, who had ‘radically changed the position’. FSA’s note records:

While [Counsel] was not yet ready to produce his opinion he was indicating that the chance of successful action for mis-selling from ’88 onwards was not negligible (although not probable). On that basis [Counsel] had asked whether, given no reserve has been set up for possible compensation costs, the Society were confident that they should make any payments beyond those to which they were contractually committed … [Equitable’s Chief Executive] had reflected further on this and considered that the Society now had to consider an alternative to the Board decision. This was to suspend all final bonus, pending resolution of the current uncertainties. In addition, he was considering refusing to allow any surrenders until the position was clearer.

FSA say that they had made it clear to Equitable that FSA had serious reservations about the reasonableness of refusing surrenders and, subject to further consideration, would be minded to take formal action to prevent Equitable from doing so. FSA’s note goes on to record that Equitable had come back to them after the meeting and that Equitable now believed that:

… provided the board decision reported above is implemented, the risks of the [Counsel for Equitable] opinion can be contained without raising solvency concerns by carefully managing the Society’s investments, particularly by moving further into gilts. This will avoid the risk of the more extreme adverse publicity.

This part of FSA’s note is amended by the Director of Insurance the following day to read:

[Equitable’s Chief Executive] recognised that there were serious problems with this more radical approach. The company would be asked why it had not taken this decision earlier, and might be accused of seeking to bring pressure on policyholders to accept the compromise. The answer to this would be that the new Board had needed time to take a fresh and thorough look at the whole problem. A second difficulty was that this response might be regarded as implying rather greater recognition of possible mis-selling claims than was the case; the decision would have to be presented very carefully to make clear that this was not so. [The Chief Executive] planned to keep both options open until the Board could be convened on 12-13th July. (Subsequently the Appointed Actuary told us that he was not convinced that the more radical option was necessary, and that he is in further discussions with [the Chief Executive]. We will be seeking further clarification as a matter of urgency). Meanwhile, at our request, [the Chief Executive] promised to send us a copy of the Board paper setting out the options for the 3rd July Board meeting together with a copy of the relevant part of the Board Minutes. Although this was now somewhat overtaken, it helpfully sets out the thinking behind the options considered at the 3rd July meeting.

Subordinated debt

Equitable’s right to buy back their subordinated debt is discussed and the Society says that, from its point of view, there were strong reasons for buying back some of the debt now.

Counsel’s opinion on mis-selling

It is noted that Counsel for Equitable had advised that the proposed change to bonuses would not undermine the House of Lords’ decision. Counsel had raised questions about whether Equitable could afford to meet the costs of any mis-selling claims. FSA’s note records:

[Equitable’s Chief Executive] expressed frustration at the fact that the likely “damage” in respect of which mis-selling damage might be claimed was likely to be, on average, about 5% of policy value; and this was well within the normal variance of returns in a with-profits fund. It was agreed that the likely outcome of the second [Counsel for Equitable] Opinion strengthened the argument for seeking to bind the potential for mis-selling claims into a compromise scheme under Section 425 …

The compromise scheme

FSA explain that the criteria for them to decide whether the scheme was one to which they should not object was still being worked on but that FSA would send it to Equitable when those criteria were ready.

Top ups

FSA remind Equitable that FSA had significant reservations about the proposal to withdraw GAR top-up rights and that FSA’s tentative legal advice was that this might be improper. Equitable agree to send FSA their latest legal advice on this and to give FSA 24 hours’ notice of any decision to implement such a change.

[20:36] Chief Counsel A sends a copy of the note of the meeting to Counsel.

In response to Line Manager E’s brief report of the meeting with Equitable on the compromise scheme, FSA’s Managing Director A asks ‘what chance do our lawyers rate a scheme like this being acceptable to the Courts on the basis of there being only 2 classes of policy-holder? It seems to me that there are a lot of interests being lumped into the GAR class?’. Managing Director A also makes two comments:

… I can’t believe that Equitable believe they can get away with the mickey mouse style of “consider the cases of Jane and Bill and see how their guarantees grow”. I still therefore do not see what policy-holder advice it would be reasonable for us to expect to be provided.

… the draft currently has nothing about misselling/giving up of other rights etc. While that may be understandable ahead of [Counsel’s opinion] we all need to remember that in reality the issues and the balancing act for the 2 classes of policyholder will be considerably more complex than suggested in the present draft.

[10:37] In response to the question, Chief Counsel A advises that FSA’s legal advisers share the Managing Director’s concern and that: ‘Counsel have not been asked yet what chances they would give this scheme because we are all agreed that two classes will probably not be accepted unless the Equitable can make the uplift (ie, how the pot/cake is to be spread within the GAR class) work more fairly. The two issues (classes and uplift) cannot be viewed separately. If there are more classes, then what happens within each class matters less (for these purposes), but we are all keen to see the number of classes kept to a minimum. To the extent the classes multiply, the scheme will become horribly complex and difficult for policyholders to understand’. Chief Counsel A also agrees with the Managing Director’s comments.

Further to the discussion the previous day (see 04/07/2001 [10:48]), the Director of Insurance says that he:

… [finds] it difficult to believe that it is simply reduced chance of insolvency that is the issue: this was certainly not the way the Society themselves have presented it in the past. I recognise however that putting firm quantification on the value of a better [equity backing ratio] is difficult and possibly spurious. But we are surely in no doubt that it is better to be in a fund which has greater investment freedom than one which is more constrained. The trick will be to demonstrate that and to include it (however quantified or qualitatively described) in the assessment of the “fair exchange” to be presented to GAR and non GAR policyholders.

Again on the “GAR Value” I recognise that this is a complex issue and I do not pretend to know how to go about assessing it. But the plain fact is that GAR policyholders perceive that they have something of value (they may overestimate it since it is currently in the money but won’t necessarily be so for ever). They are being asked to give it up. They will surely expect us to have made some assessment of how what they are giving up stacks up with what they are gaining by way of uplift and other less quantifiable aspects of the scheme. And I can’t see how the court can be expected to approve it (assuming the necessary majority of policyholders have voted for it) unless it too can get some feel for the “fairness” of the exchange since it is asked to bind in dissenting members who have voted against it.

The Director of Insurance says that this is ‘clearly very complex stuff’ and he suggests that officials should meet to discuss the matter. He also asks whether FSA needed to involve an economist in the discussion.

[10:46] Chief Counsel A agrees with the Director’s comments.

[10:53] FSA’s Insolvency Practitioner says that this would mean FSA:

… end up quantifying benefits of the scheme which are quite subjective. This makes it difficult for the detailed rationale to be made public, but I suspect we must make an attempt internally.

The credit risk factor presumably works along the lines:

Probability of insolvency if there is a scheme = 10%

Probability of insolvency if there is no scheme = 30%

Incremental costs of insolvency = £3bn

Value in having the scheme = (30%-10%)x£3bn = £0.6bn

In the same ball-park as the £1.3bn, but numbers I have plucked out of the air. The probability of insolvency is also age-related (the longer someone is tied into the Equitable, the greater the probability that it will go bust whilst they are still in).

If we are to be this subjective we might as well make an estimate of the litigation costs avoided through the scheme as well (the benefit of which would be greater if the scheme bought out potential mis-selling claims).

I tend to agree that we cannot put too much weight on a better equity return, but I think that we can attach some value given the fund has 20+ years to run.

I am not sure [Equitable’s Appointed Actuary’s] idea works. If you offer those of retirement age 60% of full GAR entitlements under the scheme with the option (expectation) that they can retire before the scheme becomes effective and take 100% of their GAR rights, then you may find that many more take up their 100% GAR rights than the 60% assumed so far. There is a risk that the fund will be depleted by more than it can afford if it is to uplift the value to younger policyholders by the amounts promised. How much risk can be taken?

I think we must have a sliding scale based on age to retirement with something very close to 100% of GAR value at the top end. There probably cannot be too much science to the shape of the curve given the intangible benefits we are asking younger policyholders to contribute towards older policyholders. All that we need is a credible stab at getting the balance right, and one which policyholders can understand.

[11:50] FSA’s Head of Actuarial Support says that he:

… [agrees] with [the Director of Insurance’s] suggestion that a meeting to discuss this would be useful, and we would certainly welcome some input from an economist about the likely value of the equity risk premium at present (ie by how much equity returns may reasonably be expected to exceed fixed interest returns over the next 10-20 years). I can see that it may be easier presentationally to use this as the proxy for the reduced risk of insolvency, even if we are not convinced that they will actually change their investment policy.

I also agree with your penultimate paragraph about the risks from [the Appointed Actuary’s] proposal. I see that their draft letter to policyholders suggests that they are attempting to offer an uplift that will “ensure” that a GAR policyholder could obtain the same annual income as if they elected to apply 75% of the fund at GAR rates. If we replace the word ‘ensure’ with something less definite, and then adopt this test with the uplifted fund applied on the best current annuity rate in the market, then we might have a suitable benchmark for the level of percentage uplift to offer those at or close to retirement.

It also occurs to me that the proposed cut in policy values will in itself very likely lead to a 1.5-2% increase in the uplift factors. In addition, it might be possible to allocate a part of the £250 million Halifax contribution specifically for the purpose of this uplift, as is half suggested in the draft letter. This combination of devices might well lead us to an uplift that meets the test that I outlined above for those close to retirement.

At younger ages, then I would agree with your point that the “credit risk” must be larger and this would seem to justify some discount factor to be applied to the uplift factor, albeit that this might be offset against the increasing value of the GAR attributable to potential further increases in longevity for younger individuals.

FSA speak to Equitable to clarify their latest thinking on how they would deal with an adverse opinion on mis-selling claims. Equitable confirm they have not reached a firm view on how they would act but had concluded that they could maintain solvency by switching almost the entire fund from equities to bonds.

Equitable also give notice to FSA that they intended not to accept any further premiums on existing terms that included guaranteed annuity rates from policyholders who had not paid premiums in the last policy year. FSA note that Equitable: ‘are well aware of the concerns we have raised about them acting on the basis of their current legal advice. On the other hand, the position is very difficult at a time when the Society is concerned about potential challenges from non-GAR policyholders, whose position is further threatened by the current practice, and also because they are increasingly concerned about statutory solvency going forward given current conditions’.

[15:26] FSA’s Director of Insurance comments that it is ‘intolerable that the Society should be left effectively rudderless [as the Chief Executive and Chairman are out of the country] with, it appears, major unresolved differences between the Appointed Actuary and the Chief Executive’. The Director of Insurance also says that FSA needed to get a better ‘handle’ on Counsel for Equitable’s opinion on mis-selling compensation and that the sums mentioned of £1bn to £1.5bn sounded very alarmist.

[16:07] The Director of GCD reports that he had spoken to Counsel, who would try to find out what Counsel for Equitable’s views were and says that the Director had told Counsel that FSA might need to be able to publish his opinion on 20 July 2001.

Equitable send FSA a note prepared by their Appointed Actuary on the terms for premiums paid on policies which included guaranteed annuity rates but where premiums had not been paid for at least one policy year. The Appointed Actuary recommends that revised terms should be offered.

Line Manager E circulates the note, commenting that it showed approximately one third of GAR policyholders still had the contractual right to obtain GAR terms on future premiums, while half had not paid any premiums in the last five years. The Line Manager says: ‘Before deciding what we should do, we need to recognise that Equitable are proposing to close the door because they believe it necessary, both for the protection of the vast majority of their policyholders, and as part of a programme of maintaining statutory solvency. We need also to recognise that they do not have much time for the concerns we have expressed and that they are likely to go ahead on some basis, unless we forcefully intervene to stop them’.

[15:04] Chief Counsel A expresses the doubts that she and Counsel shared about the validity of what Equitable were intending.

[15:16] The Head of Actuarial Support agrees that this needed careful consideration in the context of the Unfair Terms in Consumer Contracts Regulations and, [15:28] in response to a query from the Director of GCD, [15:50] clarifies that ‘While the contract (at least the example I have seen) says that if a premium is missed, then the Society may accept a subsequent premium at its absolute discretion, an associated leaflet says in effect that policyholders may follow whatever premium pattern they choose, with no mention of the Society’s discretion either not to accept premiums or to vary their terms. In addition, I am not sure about the implications of Schedule 3, paragraph 2 of the Unfair Contract Terms Regulations which could be read as requiring reasonable notice to be given of a change in the terms for accepting new premiums’. He suggests that the answer may be to wait for any complaints and then to examine their merits.

FSA’s Head of Actuarial Support writes to Chief Counsel B, further to the meeting with Counsel the previous week, at which:

… they asked us whether we could provide an estimate of the reserves that might have been set up by Equitable for guaranteed annuity options at end-93 and end-94. This estimate will of course depend on how we interpret the applicable regulations, in the absence of any specific guidance at that time.

I believe that we can make appropriate assumptions for this purpose about both the assumed mortality rates (deemed appropriate at that time) and the assumed long-term rate which is spelt out in some detail in the regulations. However, the main area of doubt would be over the level of take-up of the option that should be assumed for the purpose of determining the reserve to be made for this option.

We had a discussion on this latter point with Counsel earlier in the year, albeit in a slightly different context. His view was that we could not insist on an assumption of 100% take-up, but would have to rely on our interpretation of the word “prudent” in Regulation 72 of Insurance Companies Regulations 1994 (and of course this word does not appear at all in the corresponding regulation that applied in 1993).

If we were to assume that a take-up rate of somewhere between 10 and 40% would have met this criterion in 1993/4, in an environment where the GAR’s were only just better than CAR’s (or actually still worse than CAR’s in most of 1994), then the mathematical reserve might have been between 0.5 and 2% of total funds (or equivalently around 5 – 25% of published free reserves).

I would not have expected this to have had a material impact on bonus declarations at that time, given that they would have had various means to improve their statutory free asset ratios, and were most likely at that time expecting interest rates to remain at moderately high levels.

FSA send Counsel instructions to advise FSA on four issues relating to Equitable’s decision, without prior notice, to no longer allow the application of GAR terms to top-ups made from 16 July 2001. Those issues are:

1. the quality of the legal advice on which the Board had based its decision;
2. whether Equitable could validly withdraw the ability to top-up a policy with or without notice;
3. whether GAR policyholders had, in addition to any legal rights, a reasonable expectation that they would continue to have the ability to top-up their policy; and
4. if top-up rights could validly be withdrawn without notice and there was no reasonable expectation, were there nevertheless any implications for the compromise scheme flowing from the withdrawal of such rights.

Chief Counsel A sends a copy of the instructions to other officials at FSA, for information.

FSA’s Chief Counsel B thanks the Head of Actuarial Support for his note of the previous day on the estimate of reserves that Equitable would have had to set up for annuity guarantees. The Chief Counsel says that FSA would also ‘need to ascertain when the reserving for GARs would have had a material impact on bonus declarations, presumably some time between end 94 and 98?’. The Chief Counsel asks if the Head of Actuarial Support could give Counsel a view on this, noting that ‘time is of course pressing’.

[10:55] The Head of Actuarial Support replies:

The issue of when and by how much they might have adjusted bonus rates is very judgmental. We know that they cut the declared bonus in 1998 (from 6.5% to 5% for most pension policies) to reflect current and prospective financial conditions, but it is not clear whether they would have done this anyway even if we had not pressed them to establish a sizeable provision for GAO’s at that time.

The provision required for GAO’s at end-97 and earlier would have been significantly lower than at end-98, since a major fall in interest rates occurred during the course of 1998. In my view, it is doubtful therefore that they would have made a cut in their declared bonuses prior to end-98.

Regarding the final bonus rates, we know that they continued until end-99 to base these on smoothed investment returns with no apparent adjustment for the cost of GAO’s (as they considered the economic value of these GAO’s to be of the order of only around £100-200M). Following the [House of Lords’] judgment in mid-2000, the economic cost of the GAO’s rose to around [£1.5] billion and they therefore decided to eliminate any final bonus for the first 7 months of 2000 in order to offset this cost.

If they had followed the [House of Lords’] judgment from the start, then they would very probably in my view have reduced final bonuses at an earlier stage. This becomes very judgmental indeed, but this could conceivably have involved a reduction of 1 months final bonus in 1995, a further 2 months final bonus in 1997 and another 3-4 months final bonus in 1998.

FSA’s Line Manager E seeks an update on what was happening with PIA’s contribution on mis-selling issues to a report to the FSA Board. The Line Manager asks for confirmation of where things stood, saying that he had been asked to provide a short note about what Equitable would do to cope with any mis-selling liabilities.

[13:24] Chief Counsel B replies: ‘The position is that I am tasked to review and revise the PIA report on Equitable misselling which has looked at the history post-Court of Appeal. I am also tasked to ensure our counsel deliver a view on the misselling issues as identified by [the Society’s Counsel] and as we anticipate that will emerge in [the further opinion that Counsel is to provide to the Society]. Both these pieces of work are closely related. I think we are now aiming to have counsel’s opinion on the … issues [identified by the Society’s Counsel] ready by 20 July and I am aiming to have the PIA part of this completed by then also’.

FSA have a conversation with Equitable. According to the Director of Insurance’s note:

[Equitable’s Chief Executive] called me in response to the message we relayed to him through [Equitable’s Appointed Actuary] … whom we had met at lunchtime that day. He confirmed that he had discussed matters with [the Appointed Actuary], and was aware of his view (and ours) that the Society should not take precipitate action in response to what it expected [Counsel] to advise on misselling. He said that he had been keen that the potential need to take “extreme and radical action” should be recognised, and his purpose in raising this in the terms he had had been to ensure that planning for the eventual arrival of the [Counsel] opinion should not be on too optimistic a basis, and also that the Board, in taking decisions on the policy value adjustment we had discussed earlier should do in the clear knowledge that [Counsel’s opinion] might well lead to the need for further action in fairly short order. However he was clear that there was no question of the Board taking any decision on action that the [Counsel for Equitable] opinion might necessitate this week. He confirmed that the Society would discuss with us what such further action might involve before they committed to it.

We discussed briefly the situation that might arise if the [Counsel for Equitable’s opinion] meant establishing a provision which meant that Society was unable to meet its [required minimum margin]. I said that, if this were to occur we would, of course, look to the Society to bring forward proposals to address the situation. This might well involve a substantial further rebalancing of the Society’s funds. But we would not necessarily expect (and might not permit) this to be done over a very short period. The test for us would, of course be, whether the action and its timing was best designed to protect policyholders’ interests.

[Equitable’s Chief Executive] said he was reassured that this was likely to be our approach.

Having received Counsel’s input, Chief Counsel A seeks urgent comments on the amended draft letter to Equitable on FSA’s criteria for assessing the compromise scheme. Chief Counsel A highlights the addition, under matters of particular concern to FSA, of ‘The risk of insolvency if the scheme does not go ahead (or if the scheme does go ahead without including mis-selling claims)’. She says ‘Everyone will know why I am uncomfortable with it’.

[18:59] Chief Counsel A later sends an amended version of the letter back to Counsel to consider over the weekend. She says that FSA were ‘uncomfortable only about referring to insolvency as you suggested in a letter which may become public’.

Equitable’s new auditors telephone FSA to discuss Counsel’s opinion given to Equitable, which had suggested that Equitable could face significant mis-selling claims. Equitable were present during the call. According to FSA’s note of the conversation:

He said that he felt that the Society were in an extremely invidious position in that they were now aware of this possibility but had received no indication of the basis on which claims might be made or of the classes or cohorts of policies that might be involved. It was accordingly quite impossible to form any view on possible amounts. In these circumstances he thought that it was inappropriate to try to reach a view on the level [of] provision that might need to be established or to take precipitate action based on inadequate information. Accordingly his view, which was also the view of the Society, was that the Board at its meeting next week, should address the known problems (ie the fact that notified policy values exceeded available assets, and the need to address “top ups with GARs attached” which were still being accepted in circumstances where there appeared to be no contractual obligation to do so). Further action, if it was necessary, to deal with possible misselling should be taken in a considered fashion after full consideration of all the implications and such quantification as was possible.

The auditors say that Equitable were not expecting to receive anything further from Counsel before their next Board meeting. The note continues:

[The auditors] told me that the Society were taking legal advice to confirm that this “process” in respect of an opinion of which they had, somewhat oddly, been given a foretaste but not the full details was sound. He asked for my view. I said that we very much agreed that it was important to avoid over-hasty or precipitate action which might damage policyholders. We would, of course, expect to be kept very closely in touch with developments and to be given reasonable opportunity to comment on (and if necessary intervene in) any major decisions. But our basic approach would be to try to work in such a way as to best protect policyholders’ interests. Thus, if setting up an appropriate provision to cover possible misselling costs meant that the [required minimum margin] was uncovered we would not expect the Society to correct the position overnight (eg by some sudden and major switch from equities to bonds) if a more measured and progressive approach would produce a better result, albeit at the cost of leaving the margin uncovered for a longer period.

The implications for the compromise scheme are discussed and FSA suggest that Equitable ‘could scarcely go forward with the scheme with so much uncertainty’.

Counsel telephone FSA to inform them of a three-hour conversation that he had had with Counsel for Equitable about possible mis-selling liabilities and the compromise scheme. FSA’s Director of GCD records:

Points made [were] that:

• [The Society’s Counsel’s] opinion would continue to mention almost all the claims identified in the original, and indicate that they were all possible source of claim, in the sense that they were not negligible;
• the exception was pre-1988 claims, which he could not currently say were not negligible, though he was looking at this further;
• [The FSA’s Counsel’s] view was that [Counsel for Equitable] and his junior did not see themselves as advising Equitable, but as “free spirits giving independent advice”;
• it was said to be clear that any figures that had been supplied to us as to the value of the misselling claims had not come from [Counsel for Equitable], who had been extremely cagey about what the claims were worth;
• it appeared that [Counsel for Equitable] and [his junior Counsel] were now less bullish on contractual claims for breach of collateral warranties, but would still not dismiss them out of hand;
• in order to make such a claim work, it would be necessary for the court to imply contrary terms into the contracts of GAR and non-GAR policyholders, and the effect of this would be to increase the overall liabilities of the Equitable, rather than simply to require a different sharing of the same pot;
• there was a stark contrast between the approach which [Counsel who was advising the Society on mis-selling issues] was taking and the approach which had been taken by [junior Counsel], who was advising the Equitable on the GAR scheme along with [Counsel];
• this was because [the Society’s Counsel] had been under the clear impression that his work was going to be factored into the 425 scheme, while those who were working on the 425 scheme were clearly of the view that misselling would be kept out of it;
• in particular, the draft board paper on the 425 scheme had referred to misselling only as a procedural point, indicating that the scheme would not affect misselling claims;
• it was clear that [Counsel for Equitable] had been surprised at the idea that the misselling claims would not be included in the scheme;
• our own Counsel expressed doubt that tortious misselling could be included, given that its value will vary from person to person: on any basis, the effect would need to be explained very carefully;
• [The Society’s Counsel] and his junior take a more absolute approach to the construction of the regulatory rules than [Counsel for the FSA] and [his junior Counsel], but consider that even if some fault on the part of Equitable were required in order to show liability, that fault could be established on the basis of the paper [With Profits Without Mystery] produced by [Equitable] in 1988 and 1989, which in [Counsel for Equitable’s] view showed that they knew that they had a problem, but ran away from it;
• accordingly if it were concluded that the rules simply required disclosure of that risk, [Counsel for Equitable’s] view would be that there had been a material risk from the time policies had been issued, because he had been told that if the true position had been given, no one would have bought these policies rather than those from another provider;
• the view that [Equitable] knew the true position in 1988 and 1989 is based both on his published actuarial paper “With Profits Without Mystery” and on a meeting note from that date;
• it was clear that [the Society’s Counsel] was not going to be dissuaded from saying that there had been misselling back to 1988 and 1989;
• it was clear that the Equitable had not taken legal advice at the time they introduced their differential bonus policy about the validity of such a policy;
• it could not be assumed that if they had taken advice before they had introduced the policy, it would have been the advice given by [Counsel] when he was consulted;
• in [Counsel for the FSA’s] view, it was difficult to imagine that the 425 scheme would be sellable without including misselling in the accommodation;
• this was because the GAR holders would be asked to give up all their rights, but would know that the rights of the non-GAR would be maintained, and this could only [lead] to smaller bonuses for the GAR holders, undermining the value to them of the deal they had accepted;
• there were, however, two counter arguments to the view that misselling claims had to be included in the 425 scheme;
• the first was that the Halifax deal was conditional only on the compromise of the GAR rights, not on compromise of the misselling claims, which could complicate the deal;
• the second was that if [Counsel for Equitable] was right to believe that there were contractual claims, their scale might be such that it was practicable for them to be adjustable only by a liquidator or administrator.

FSA’s Head of Actuarial Support meets with the Independent Actuary for the compromise scheme. Included in the issues arising from the meeting and under the heading ‘Principles of Financial Management’, the Head of Actuarial Support records:

The scheme should result in an improvement to the Companies Act balance sheet of around £500-600M from removing the value of the GAR and replacing this by an uplift of 17-22% to the guaranteed fund; plus also the Halifax contribution of between £250M and £500M.

This will reduce the risk of insolvency, thereby allowing Equitable slightly more investment freedom and the possibility of a slightly higher ratio of guaranteed to non-guaranteed bonuses in the future.

There is though no indication as yet by Equitable of how this scheme is expected to affect their investment policy, bonus philosophy (including smoothing), MVAs on surrenders (for both GAR and non-GAR policies) and current annuity rates (the latter may not be too important as long as policyholders retain the right to take the funds elsewhere on retirement without penalty).

This information will be important to both a qualitative and quantitative assessment of the scheme by policyholders, the independent actuary (if this is within his terms of reference) and FSA.

For example, some assurance is needed that the uplift provided to the non-guaranteed element of policy values for GAR policies cannot be unilaterally removed, other than in the context of some equivalent reduction of final bonus for all policyholders.

We would also expect to see both GAR and non-GAR policyholders treated similarly in the event of early surrender.

FSA’s Head of Actuarial Support asks the Director of Insurance if Equitable’s auditors or their  Appointed Actuary had expressed a view on 06/07/2001 as to whether the company was still solvent, as: ‘It is not at all clear to me from the limited information provided at present that there is much margin at all on a Companies Act basis, particularly if they have in due course to make any material provision for mis-selling claims’.

[10:31] The Director of Insurance says that Equitable had told them that they were solvent as at end-June but ‘that, I am pretty clear, was before any provision for misselling claims’. The Director concludes: ‘At this stage, before either their counsel or ours has opined, it is very difficult to see on what basis such a provision could be made. But the fact that the Society’s auditors are (now) being fully involved gives me some comfort’.

FSA’s Insolvency Practitioner prepares a paper entitled ‘Equitable Life Counter-factuals/Contingency Planning’, which sets out eight scenarios where difficulties might arise for Equitable policyholders. The scenarios are:

1. Solvency deteriorates.
2. Policyholder petitions for winding up.
3. Society becomes insolvent.
4. Society announces that terminal bonuses are not sustainable.
5. Society removes rights to top-up GAR contracts.
6. Counsel for Equitable’s final opinion supports mis-selling actions.
7. Timetable slips – Scheme cannot be sanctioned before 1 March 2002.
8. Scheme is rejected by creditors or not sanctioned by the Court.

FSA hold a conference with Counsel on the rights of Equitable policyholders to pay top ups and on Counsel for Equitable’s opinion in relation to mis-selling liabilities. Counsel advise that Equitable could seek not to allow further top ups only if they gave notice of this to policyholders, but there was also an argument that they could not now do so at all.

On mis-selling, Counsel agrees to provide a ‘bullet type opinion’ in response to Counsel for Equitable’s ‘Stage 2’ opinion. The note records: ‘This short opinion was likely to indicate that any claim based on contractual rights by non GARs was weak/unsustainable and that mis-selling was from 1995 and not 1988’.

FSA’s Director of GCD suggests that FSA should consider whether Equitable should soon be seeking advice on trading while insolvent.

[13:43] The Director of Insurance replies:

Do you mean legal advice? If so I am not entirely sure what value it would add. If you mean advice as to what provision might be required in these circumstances (which is essentially a matter I think of “accepted accounting practice”) the advice might best come from their auditors, to whom they are already talking (see my note of my conversation with [Equitable’s new auditors]).

Where lawyers might really help would be in advising on the nature of any misselling claims that might arise, what form of compensation might be appropriate, whether the causes of action are broadly similar (so that they might stand or fall together) or whether they are various and dissimilar. It is precisely on these points that the auditors feel the Society are being ill-served by [Counsel]. Given this information the company could make a reasonable attempt at deciding what should be provided. But for the present the advice the auditors are giving is that the contingent liability appears to be too difficult to quantify to make it appropriate to provision.

I think we have to bear in mind that what trading means in the case of the Society is paying out money; annuities, maturity payments, surrenders etc. Deciding to stop trading would mean, in practice, stopping all payments. Is this what you have in mind?

FSA’s Line Manager E seeks comments on a further draft of a letter to be sent to Equitable about FSA’s criteria for assessing the compromise scheme. Following comments by Chief Counsel B, the Head of Life Insurance and Line Manager E, [15:35] the Director of Insurance says that the letter must be issued by 12 July 2001, and should be again checked by Counsel and shown to FSA’s Chairman and Managing Director B immediately for their sign off.

[16:26] Line Manager E circulates a revised draft of the letter and says that he would prepare a note to the Chairman and Managing Director B.

Following some of the initial discussion that morning about the draft letter to Equitable on FSA’s assessment criteria, in which Chief Counsel B had suggested that FSA should ask for urgent clarification on whether Equitable intended to include mis-selling claims in the compromise scheme, Line Manager E says that Equitable have been:

… fairly clear with us that they will take a view on whether mis-selling claims can and should be caught up in the scheme when they have a better idea about the scope, scale and likelihood they have of success. Understandably, Equitable does not want to try and deal with a problem that has yet to prove it exists (though clearly we are getting closer to reaching a view that it probably does to some degree). Accordingly, I would rather put that question once the legal advice has been given, and ideally when we have reached a view, as promised in our memorandum to the Select Committee.

He also queries a point made in a note from the Director of GCD that both Counsel for Equitable and for FSA did not know how the mis-selling issue was being taken forward by Equitable.

[15:07] The Head of Actuarial Support says that his understanding was that:

[Counsel] is looking at possible mis-selling claims for all with-profit policies sold from around 1996 as being a possibility (though his view may well differ from [Counsel for Equitable] who has so far come at this from a rather different angle). The present policy values in respect of this business are likely to be of the order of £10 Bn, so that if the quantum of claim were say 15% of policy value (and it could be higher on the approach he is looking at), we could have mis-selling liabilities of £1.5 bn or more.

In present investment market conditions, this would very likely mean that the company was insolvent. Therefore, the Section 425 Scheme would take on quite a different flavour, as it would be the means to restore overall solvency. I am not sure that it is practicable for us to expect the Society to modify the scheme so fundamentally at this stage unless or until we receive confirmation that there are likely to be mis-selling claims of this magnitude.

[15:13] The Director of GCD suggests that ‘the alternative [is] even more unattractive – that [Counsel] gives his advice and there is no plan to deal with it’.

[15:16] The Director of Insurance says that he thinks FSA ‘really do need some harder information before we try to take a firm position. There is a danger that too much speculation (which is all it can be at this stage) however well informed will lead to precipitate action which will not best serve policyholders’.

[15:18] The Director of Insurance says that FSA needed some scenario planning and asks that the Insolvency Practitioner’s work (see 09/07/2001 [13:08]) should be expanded.

[15:32] FSA’s Insolvency Practitioner circulates his work to a wider audience in FSA.

[16:00] The Head of Actuarial Support comments:

In this context, it would be very useful to have a figure from them for the total statutory value of the Society’s tangible assets as at 30/6/01 (any admissibility percentage limits could be ignored for this purpose). In one board paper, these are estimated on the assumption of a 0% rate of investment return for 2001, while a second Board paper assumes a -4% rate of return. Even this small difference could affect their present solvency and resilience to further market changes.

Another point to consider in this note would be the effect on the society’s reinsurance arrangements, and in particular the liabilities that were reinsured to Halifax … I am not sure what would happen to these in the event of a liquidation.

The value to be placed on the GARs in a liquidation is another area of uncertainty that would need to be raised with Counsel in that event.

In Appendix B, I don’t understand how implicit items such as future profits could be included in a test of solvency.

FSA’s Head of Actuarial Support prepares an analysis of the two Board papers on bonus declarations supplied by Equitable. This comprises two lists of the advantages and disadvantages of option 1 (reduction of policy values by 15%) and option 2 (eliminate interim bonus from 1 August 2000 (i.e. a reduction of 7.3% in policy value)).

On option 1, the Head of Actuarial Support states:

Advantages

• Preferred option of management/chief executive
• Achieves near balance of Aggregate Assets with Policy Values at present time
• Avoids potential losses if large number of policyholders opt to retire now
• Financial adjuster on surrenders reduced to 5% (but overall they become 5% worse off?)

Disadvantages

• Systems problems with implementation
• Possible inconsistency with PRE
• Concerns that payouts should be smoothed (why has Board not acted before now?)
• Revised policy value is around 5% lower than value shown to policyholders as available for transfer as at 31/12/00
• Possible unfairness for policies written since around 1990 relative to others
• Adverse PR for society
• Loss of confidence in board
• Difficulty in getting acceptance by policyholders for S425 scheme
• Increased likelihood of mis-selling claims

On option 2, he states:

Advantages

• Preferred option of appointed actuary in 21 June Board paper
• Looks more plausible in terms of investment returns since January 2000
• Allows some degree of smoothing in payouts
• Administratively less costly
• Policy values still higher than amount shown as available for transfer at 31/12/00

Disadvantages

• Society still vulnerable to sudden increase in numbers of retirements (though a cut in final bonus as in option 1 could be implemented at a later date)
• Financial adjuster on surrenders likely to remain at significant level, (though probably reduced to around 7.5%)
• Some adverse PR though less than for Option 1
• Imbalance remains between Aggregate Assets and Policy Values (though may not be necessary to disclose this previously unpublished figure with S425 scheme)

The Head of Actuarial Support says that he was ‘somewhat concerned’ about some significant discrepancies in the figures in the papers. He notes that Equitable’s Appointed Actuary had recommended a relatively modest reduction in bonus, whereas the Chief Executive had recommended a ‘much more drastic’ cut in bonuses. The Head of Actuarial Support suggests that FSA should talk to the Appointed Actuary in order better to understand the situation and to ascertain whether the Appointed Actuary was content with the more drastic option that was being considered.

[18:21] Line Manager E responds:

I have had some difficulty getting to grips with the relevant papers, but are the numbers so different? Both the management paper and the appointed actuary’s report indicate that policy values exceed asset shares by 15-16%. One paper does not contemplate cutting terminal bonus going other than by a further adjustment of the interim rate of return for the recent past. The other is more radical in that it proposes cutting policy values back to match the assets. But equally, the less radical option acknowledges that it does not actually solve the problem – it just means that … ongoing it would not be quite as bad as it might otherwise have been and that further measures will be needed over time to keep things under control.

Would it help if I asked [Equitable’s Appointed Actuary] to clarify why/when the relevant papers were prepared and considered? It may be that they were produced for different purposes that is not immediately apparent. For example, we know that before the returns were submitted the board considered the issues but failed to decide how to act. There was then a further paper that we were told contained more analysis on the basis of which the board later took its view. It could be that the [Appointed Actuary] signed paper was their first shot, and that it had then to be developed into the more radical option (though less radical than some others that [the Chief Executive] has come up with, and which [the Appointed Actuary] had been unhappy about!).

Equitable send FSA copies of four papers discussed at their Board meeting held on 3 July 2001, as requested by FSA on 04/07/2001. The four papers are:

• FSA Returns, Policy Values and Bonus Rates, dated 21 June 2001, prepared by the Appointed Actuary.
• Note on Solvency Position at 2000 and Prospects in 2001, dated 21 June 2001, prepared by the Appointed Actuary.
• Note on Society’s terms for premiums paid into policies which have GAR benefits, but where premiums have not been paid for at least one full policy year, dated 21 June 2001, prepared by the Appointed Actuary.
• Bonus Declaration, dated 29 June 2001, prepared by the Chief Executive.

1)FSA Returns, Policy Values and Bonus Rates

In this paper, the Society’s Appointed Actuary sets out the broad position as would be revealed by the returns for the year 2000, once submitted, and highlights some issues which arise. The Appointed Actuary says that he believes that:

… it is only appropriate to present these Returns in their present form if the Directors address urgent issues, and that the Society is run with tight control. The urgent issues are bonuses credited on with profits policies for 2001, and changing the terms for new premiums on GAR policies where premiums have not been paid in the previous policy year.

The paper includes the following presentation of Equitable’s financial position at the year-ends 1999 and 2000:

Form 9 reveals the following position ([figures] in £m)

Equitable’s Appointed Actuary notes that the Society’s financial position had deteriorated over the year, despite no ‘significant’ declared bonus being added. He also says:

It should be noted the £411m of free assets is after taking credit for the reinsurance benefit (£808m) and future profits (£1000m). It also ignores the value of the subordinated debt liability of £346m.

These are all permissible and previously agreed with the FSA. However, their use clearly eats into any conservatism in the basic valuation regulations.

The Appointed Actuary goes on to explain:

In setting and reviewing each element of the valuation basis I have endeavoured to ensure that each assumption is at least prudent and is backed up by a suitable analysis of experience.

Compared with the valuation assumptions used at the time of the Report and Accounts the only significant change is to add an additional reserve of £150m. This is in respect of adding some margin to the mortality assumption and also to provide for possible costs and payments on the Managed Pension Review. In addition a resilience reserve is included and the treatment of the GAR reserve is different using conservative assumptions but including the reinsurance.

In arriving at the valuation, specific assets are hypothecated to particular liabilities, and reallocated in the resilience scenarios. I believe that the process we used is close to the best achievable.

Overall I think that whilst prudent in all respects according to the valuation regulations the Directors should be aware that it would, in my view, not be possible to produce a satisfactory valuation which produced a materially higher net asset position at 31/12/2000.

Under the heading ‘Managing the Society in 2001’, the Appointed Actuary reports:

In the first 6 months of 2001 investment returns to mid June were broadly zero (or slightly negative). This was particularly true of UK equities (FTSE 100 index at 31/12/2000 was 6222). This will have adversely affected solvency. The passage of time will also have increased guaranteed liabilities where there is a 3½% interest rate guarantee. Against this the Society received £500m (or say £300m net) from Halifax. (The Permanent sale value was already credited in the 2000 returns). The Society also sold some more equities, although the impact of this has been eroded by claims outflow.

Claims (both surrenders and maturity) are running at a much higher level this year compared with last year and with profit premiums are very modest.

When with profits policies mature the final bonus (which is not reserved for) crystallises. On the other hand, resilience reserves are released and unless an annuity is taken with the Society the 4% solvency margin is released. In the case of surrenders the 15% financial adjustment comes off the final bonus.

In the first 3 months of 2001 £1290m of with profit policy value matured or surrendered with a final bonus of £328m. The financial adjuster saved £29m and hence actual payouts were £1261m with a final bonus element of £299m.

The Society’s Appointed Actuary continues:

If first quarter experience were repeated then total claims would be £5.0bn with final bonuses of £1.2bn and therefore a release of guaranteed fund of £3.8bn. The release of resilience reserve on the £3.8bn guaranteed fund might be anywhere between say 6% and 33% of the guaranteed fund. The 33% assumes that we are hypothecating 100% equities to the business going off the books. 6% assumes that the resilience reserve reduces pro rata to the with profits fund. This produces a range of resilience reserve release of between £0.2bn and £1.3bn. Therefore, at best the only addition to free assets would be say 4% of £3.8bn or £152m. At worst, there would be a deterioration of around £850m.

In order to mitigate the adverse effect we could reduce the equity backing ratio.

Under the heading ‘Policy Values and Asset Shares’, the Appointed Actuary says that ‘[as] well as considering the statutory position the realistic position also needs attention’. He reports:

At this moment (FTSE 1000 at 5700) policy values are around 16% above asset shares. The interim final bonus rate we are using is 8% per annum for 2001. The financial adjuster we are using (of 15%) means that surrenders are at around 99% of asset shares. The figure clearly fluctuates from day to day with investment markets, but policy values are increasing by 8 % p.a. relentlessly.

Given the tight financial position of the Society it seems perverse to be paying out 16% more than asset shares. In addition this rate of increase of 8% is higher than we would reasonably expect the Society to be able to earn net of management expenses, and recouping present overpayments.

An indication of a sustainable rate would be

In practical terms the most we can do in cutting policy values today is to eliminate any interim bonus additions for the year 2001 in effect reducing calculated policy values today by 4%.

Going back further would effectively go back on what was said in respect of 2000. Going forward we do not wish to set the interim rate below a reasonable gross return on a balanced portfolio, as this would encourage people to retire/surrender immediately. Therefore a 6% rate seems appropriate.

The Society’s Appointed Actuary goes on to say that:

The effect of 4% reduction would be to “save” some £200m in policy value payment in a full year which is entirely from the final bonus.

This is clearly a modest step but combined with the reduced accumulation rate would reduce the problem, and stop it “running away” on business that remains in force. Incidentally the policy value overpayments are ultimately paid for by continuing policyholders in extra “smoothing” charges.

There is clearly a risk that this move will be seen as a further sign of weakness of the Society. However, it is interesting that S&P are concerned about this issue and think we will not address it.

The Appointed Actuary’s paper concludes with the following recommendation:

As a result of the above analysis, I recommend that the Directors reduce the increase in policy values since 31/12/2000 to zero (where possible) and that from 30/6/2001 the interim rate should accrue at 6% per annum. A formal resolution will be tabled which gives details of the proposed changes.

It was agreed at the Investment Committee that the equity backing ratio (including relevant commitments) should be a maximum of 61½% of the with profits fund.

As illustrated above, this may be insufficient to maintain the solvency margin on its own, particularly if investment markets remain depressed. The Society should therefore monitor the position closely and if necessary reduce the equity backing ratio to improve solvency.

In any event it will be essential to ensure that cash movements and asset exposure are tightly controlled in order to avoid “accidental” exposure to falling markets.

I have stated in the FSA returns that I do not believe that it is appropriate for the Society to contemplate any additional reversionary bonuses until the Society’s solvency position is significantly stronger. This might be if investment markets have risen significantly and the compromise scheme is concluded. Such a rise in markets would also be the opportunity to eliminate the gap between policy values and asset shares.

Given that even with the 4% interim policy value increase removed the Financial Adjuster only reduces surrender values to 95% of ongoing asset shares I recommend that no change is made to the financial adjuster.

2)Note on Solvency Position at 2000 and Prospects in 2001

In his second paper, the Society’s Appointed Actuary sets out the principal reasons for the change in Equitable’s statutory solvency position during 2000. The Society’s solvency position is set out in greater detail than in his first paper (see above), and is as follows:

The Appointed Actuary points out that the largest single factor that had caused the deterioration in the Society’s free assets was the impact of the changes in the reserves established in respect of annuity guarantees. He explains that the main changes to the level of these reserves were due to:

1. GAD guidance expects the reserves to assume that almost all policyholders exercise their GAR options. In the 1999 returns it was assumed that 85% of policyholders took GARs. With the House of Lords’ judgment that has been increased to 90%.
2. … the reinsurance treaty had to be renegotiated following the House of Lords’ judgment and now allows the Society to assume a net take-up rate of 60% (25% at 31 December 1999).
3. Interest rates at the end of 2000 were generally at a lower level than at the end of 1999. That leads to a higher reserve as does the strengthening of the annuitant mortality basis.
4. The assumptions for the level of future premiums to be assumed have been increased.
5. New valuation regulations were introduced during the year which reduced the rate of interest for future cashflows again leading to higher reserves.

The paper sets out an analysis of the changes in the reserves in respect of annuity guarantees. The Appointed Actuary reports that:

The above analysis “explains” some £1.7bn of the £2.2bn change in free assets (increase in GAR related reserves of £1.5bn and additional reserves etc of £0.2bn). The rest of the change is for a wide variety of reasons. However, in the rest of this note the impact of the crystallisation of final bonus is highlighted alongside the change in respect of basic liability values.

The Appointed Actuary’s paper then addresses the changes in the value of the Society’s assets over the year (which had increased by 3.1%), along with the changes in the basic mathematical reserves (which had increased by 5.3% or, if premiums received in the year less claims made and expenses incurred were taken into account, by 6.7%). He explains:

Essentially therefore, if we assume that the 3.1% asset increase looks reasonable we need to explain why liabilities (including payouts during the year), increased by 6.7% (i.e. 3.6% more than “expected” or £1bn).

This amount could be partly explained by:

• additional reserve £150m
• crystallised final bonus £545m (from Form 58 of the FSA Returns)

This would leave miscellaneous strengthening etc of £300m. That would be plausible based on mortality changes and possible losses on non profit liabilities.

Broadly we would expect that as basic liabilities (including the GAR reserves) increased compared with assets the resilience reserve would increase. However, this is not the case.

It is believed that this is explained by the s68 order allowing a “pooling” of the fixed income return on the fixed interest holdings and the more sophisticated allocation and reallocation process used at 31/12/2000 but also and importantly, because the release of reserves through maturity payments can have an opposite effect to the final bonus payment.

FSA sideline the final part of the last sentence and mark it with ‘?’.

In the remainder of his paper, the Appointed Actuary provides estimates of the possible position of the Society as at 30 June 2001 and 31 December 2001. These estimates, based on certain assumptions, showed free assets at those dates of £338m and £511m, respectively.

3)Note on Society’s terms for premiums paid into policies which have GAR benefits, but where premiums have not been paid for at least one full policy year

The third paper prepared by the Appointed Actuary considers the issue of the contract terms for GAR policyholders. He explains:

Most of the GAR policies clearly state that if premiums are not paid in any policy year future premiums are accepted by the Society on terms which it decides. Until now the Society chose to allow such premiums to be on GAR terms. Prior to the House of Lords Judgment this seemed fairly neutral, and was administratively convenient. Any “anti selection” was, I believe, minimal.

Since the Judgment this ceases to be the case. In view of the Society’s position it is clearly important to avoid any unnecessary further liabilities. I therefore recommend that we offer revised terms for new premiums on such policies with immediate effect and reflect this in the Section 425 Scheme.

The Society’s Appointed Actuary provides an analysis of the premium paying characteristics of policyholders, which shows the following:

4)Bonus Declaration

The fourth paper considered by the Society’s Board, prepared by the Chief Executive, considers the issues of bonus methodology, the relationship between policy values and asset shares, and the Society’s smoothing assumptions.

By way of introduction, the Chief Executive says:

Policyholders are sent an annual statement … and accompanying leaflet … which sets out the guaranteed fund at a certain date, and the policy value at that date. From this and the With Profits Guide it can be seen that it is clear that “maturity” payments are targeted to be asset share (subject to being not less than the guaranteed amount). Whilst it is not specifically stated that maturity payments can be less than a recent policy value quoted on an annual statement, the statement makes it clear Final Bonus is not guaranteed and may vary. It is stated that the actual amount payable will be determined when benefits are taken. This clearly means that the final maturity payment can be less than the amount quoted on the annual statement.

FSA underline the words ‘Whilst it is not specifically stated that maturity payments can be less than a recent policy value quoted on an annual statement’ and write next to them: ‘PRE?’. FSA also underline the final sentence and mark it with ‘?’.

Equitable’s Chief Executive highlights the differences between the Society’s approach and that of other companies, explaining that:

The Society’s approach is different to other with profits offices for pensions business (but similar for life business). Typically bonuses are declared in two forms, a reversionary bonus which adds to the guaranteed fund (or sum assured). The Society’s declared bonus (nil for the 2000 year) is similar to this reversionary bonus. However nearly all other offices show a “terminal bonus for policies becoming claims in 20XX”. No comparative figure is shown for the previous year, and there is no explicit way of finding out how this has been calculated for any particular policy. The policyholder can compare the terminal bonus with the previous years statement and can read the With Profits Guide if he requests such a guide.

The Chief Executive then explains to the Board the operation of with-profits business and the smoothing of returns. He reports:

With-profits business tries to smooth by holding back investment returns when they are very high in order to subsidise them when they are low … For smoothing to work, there should be at least as much flowing in by holding back investment returns as flows out. The free assets cannot be allowed to run out during the bad times so either smoothing must be more tightly controlled (i.e. a trend line which follows the market more closely) or there must be large free assets.

Most companies now express their total payout policy in terms of asset share. Therefore terminal bonus is essentially aimed at paying out asset share. Typically an office would wish to avoid paying out less this year than last year on the same policy, but provided there is sufficient terminal bonus there is no reason why this should not happen …

The Chief Executive continues:

The difference between payout and guaranteed amount is stated as the terminal bonus applicable to that policy for maturity or claim that year.

The key difference compared with the Society is that the terminal bonus has no “history” of build up over the years and clearly only applies to that year. For all companies however final or terminal bonuses can be reduced and changes can generally be made at any time.

The Board paper then turns to the current position of the Society compared with smoothing assumptions. The Chief Executive reports:

A summary of the position at 31 December 2000 and an estimate of the 30 June 2001 position are shown below. This assumes that the return over the 1st half of 2000 has been about -4% and policy values (PV) have increased by 4%.

[Note: The usual annual updates of policy values to 31 December 2000 have not yet occurred as the declaration was deferred. Therefore there are more estimates than usual in the policy value totals above which may be up to 2% overstated.]

The Society’s Chief Executive advises that:

The worsening of the ratio of policy values to asset shares from 31 December 2000 to  30 June 2001 of 120.7% is due to the continuing roll-up of total policy values at the interim rate of return at 8% p.a. (4% for the year-to-date) and due to the total return on with-profits assets of around -4%.

In another office it would not be surprising to see some payouts compared with asset shares at up to 120% of asset shares, especially for very long policies but the average would be much lower. Also other offices would tend to have more regular premium business and also new business to “dilute” the effect over time.

Lastly they would have an “estate” or excess capital so that this overpayment was, if it came to it, covered by assets. The Society currently represents to policyholders that their aggregate interest is £30bn when in fact it is only £25bn. Clearly for the Society to be able to smooth returns at all there needs to be some ability to have policy values above the available assets but the amount of the excess seems too great in present conditions.

Under the heading ‘Policyholder options against smoothing’, he also advises the Board that: ‘The Society is also unique in having such a large proportion of its liabilities in the form of pension policies where policyholders can retire immediately (and hence take full benefit (in many cases with GAR benefits.)). It is estimated that £6.7bn (40%) of the guaranteed with profit liability is in this position’.

The paper then covers the discussion that had taken place at a meeting of Equitable’s Board on 27 June 2001. At this meeting, the Appointed Actuary had presented his paper ‘FSA Returns, Policy Values and Bonus Rates’ (see above). The Chief Executive records the following from that meeting:

The Board agreed that the current position was not sustainable. In particular the matters that the Board were concerned about are:

1. Policy values exceeded asset shares by approximately 10% at 31 December, and the position has deteriorated to approximately 20% currently. Although these values include “indicative” final bonuses which are not included for the purpose of FSA returns, the excess needs active management (for the reasons given … above).
2. Policyholders who are electing to retire and invoke a maturity claim are generally withdrawing cash in excess of asset shares even before allowing for the cost of any GAR. This results from over allocation of bonuses in the period before 1991 as well as from the poor returns of the past 18 months. Subsequent reductions in bonuses have affected younger policies as well and have not addressed the over allocation to older policies.
3. The Board believes some disclosure to policyholders of the financial position of the Society will be necessary at the time of launching a [compromise] scheme, and disclosure of the current excess would not be acceptable to the Board or to policyholders.

The Chief Executive notes that no conclusions had been reached by the Board at that time. The paper then sets out some possible alternative bonus declarations in order to correct the problem, those being:

• a change in the interim rate;
• a percentage change in policy values;
• a percentage change in final bonus; or
• to move to a policy value which reflected the asset share build up on a year-by-year basis.

Under the heading ‘Financial Impact of Bonus Changes on the Society’, the Chief Executive says:

It is helpful to consider the impact on premiums paid at different durations to assess how “fair” any particular basis is to individual policyholders. Due to the flexible nature of the Society’s recurrent single premium contracts it is not possible to look at the position of policies taken out in any one year as each policyholder will have paid a completely different pattern of premiums but we can look at the position of a single premium paid in a particular year. A policy will be made up of a series of such premiums.

The paper continues:

The table below shows an estimate of how policy values and asset share (after deduction of the best estimate cost of GARs) compare for premiums paid of a £1,000 investment content on 1 January 1980 through to January 2000. The asset shares calculated here … do not take account of any profits or losses from running the business including from past smoothing of with-profits payouts. They can therefore only give an indication of the “true” underlying position and the pattern year by year.

The Chief Executive’s paper sets out the potential financial impact of the four options for changes to the bonus declaration, as well as the likely impact of each change on: policyholder behaviour; public relations for the Society; and, the Compromise Scheme.

The paper addresses the practical implications of implementing each of the options, before going on to consider ‘Consistency with past statements’. In this section, the Chief Executive explains:

The Society has always made it clear that final bonus is not guaranteed and is only finally set when a policy matures. The Society has had a policy of transparency and policyholders are shown the total accumulating value (including final bonus) on the annual statements. An example annual statement is attached … with some key paragraphs highlighted. All

the options for reducing final bonuses are therefore possible in that final bonus is not guaranteed and may be removed but some options are less consistent with other statements which have been made to policyholders which will have set their expectations.

For the option of making a change in the interim rate, the Chief Executive says:

… the ratio of policy values over asset shares has increased by 10% since 31 December 2000 as there has been a gap of 10% between growth allocated to policies and the returns earned. A change to interim growth rates from either 1 January 2001 or 1 August 2001 should be justifiable to policyholders as they will reduce policy values by 4% and 7.3% respectively.

As part of the consultation on the [compromise] scheme, we have commented that the fund is now more unstable and so more erratic changes are likely and should be expected.

For the option of making a change as a proportion of policy value, the Chief Executive says:

A deduction from the policy value (at 31 December 2000 or at a later date) of much more than the 10% would be difficult to defend in terms of policyholders’ reasonable expectations as the leaflet which accompanied the annual statements … and the Report and Accounts made no explicit mention of the overdistribution at 31 December 2000. However, the financial adjuster of 10% was clearly explained including reference to the market level of assets.

[The Society’s Chairman and Chief Executive] have also made strong arguments in defence of the Financial Adjuster to the OFT, FSA, and policyholders. Those arguments have stressed that continuing policyholders are being protected by the Financial Adjuster and that it is possible to pay a smoothed value to maturing policies but not to those surrendering … To now argue that smoothing on maturity is not possible would put the Chief Executive and Chairman in an extremely vulnerable position.

A more drastic cut in policy values should the [compromise] scheme fail would be much more consistent with policyholders expectations as the management team has been consistently saying that the [compromise] scheme is needed to allow the fund to be run in a less volatile - manner without the scheme the fund is fundamentally unstable. If the scheme was not voted through the policyholders should expect much more drastic action.

For the option of making a change as a proportion of final bonus, the Chief Executive says that:

The method that has been used to produce the current policy values has been in place since 1989 and policyholders have consistently been told that the Society has passed across fair and reasonable values within the constraints of smoothing. As we have made no reference to over distribution by duration, to hit some policies by a much greater proportionate cut in payout values and justify it by saying they had been given too much compared with younger policies would be open to criticism that it was inconsistent with PRE. Although smoothing always means that some cases will be over and some under distributed, past statements have not indicated that this will need to be “corrected”.

GAR policies have final bonus proportions greater than the average across all policies … and the lack of past statements that such a change may be introduced would leave the Society open to challenge that the House of Lords’ was being undermined.

For the option of making a change to using a duration related scale, the Chief Executive says that this could appear to run counter to the House of Lords’ decision. He also says that to move to a less transparent method of allocating bonuses would be inconsistent with policyholder expectations.

The Chief Executive’s paper concludes with the following ‘Management Proposal’:

On the basis of the foregoing, and the need to get all the bad news out, the “best financial option” seems to be a cut in policy values of 15%. This is based on a FTSE 100 level of 5600. The interim bonus rate would be set at 6% p.a. ongoing with a clear message to policyholders that the position will be kept under review. On that basis, a 5% financial adjuster would seem to be appropriate. Clearly major policyholder and PR issues need to be overcome but we believe that this is the fairest option in the interest of all policyholders.

FSA’s Director of GCD responds to the Head of Actuarial Support’s note of 10/07/2001 on the Board papers supplied by Equitable. The Director of GCD says:

This is reassuring if it means that, on likely position as to misselling these two options are still available – less so if not. My only other point relates to PRE. We need to recognise, as [the Director of Insurance] has recently pointed out, that PRE is not a legal entitlement to a particular asset share, or method of calculation. It is a trigger for regulatory action. May be more helpful to consider interests of policyholders.

[11:13] The Head of Actuarial Support comments:

If a significant liability or contingent liability falls to be recognised on the balance sheet for mis-selling, then this is likely to increase the necessity for such action on bonus rates, and most likely push them towards the more drastic option (for which they could then use the mis-selling issue as part of the rationale for this cut in bonuses).

However, I don’t think that potential mis-selling is mentioned as one of the factors to be considered in either of these two papers. Therefore, they would no doubt need to prepare a further paper to look at the wider implications. This would also need to consider the potential impact on their immediate solvency which would not be resolved by simply cutting final bonus rates.

On PRE, I seem to recall that the Scott judgment said that this was a factor but not necessarily the only factor that a company should take into account when exercising its discretion. In this present context, I can well see that there would be a range of issues to weigh up in terms of protecting consumer interests, and that these could also influence FSA when considering the possibility of any regulatory action.

[12:55] The Head of Actuarial Support also comments on Line Manager E’s response of 10/07/2001, saying:

I think it would be helpful to have a chat with [Equitable’s Appointed Actuary] when he comes here tomorrow, after the S.425 meeting, about the content of these papers, some of which (eg the 40% proportion mentioned in paragraph 1.5, and the table in Section 4) look quite surprising.

His paper says that policy values exceed assets by around 15-16% but the later [Chief Executive] paper quotes a figure for this ratio of 21% (which would indicate that the 15% financial adjuster on surrenders is now out of line with underlying asset values). The key difference appears to be in the assumed investment return for the year to date.

At one stage, I know that Equitable were on monthly financial reporting to us but I have not seen one of these reports for a while. It would certainly be very helpful to have a figure from them for the aggregate value of tangible assets as at 30 June this year.

[13:01] Line Manager E adds:

That sounds sensible to me. I think the monthly reporting was an informally agreed arrangement. However they have been falling down on that and if they do not pull their socks up and get back into the habit of providing the information on a timely basis, I think we should consider exercising formal powers. We will put together a short letter asking for the missing information – [Line Supervisor C] can you (get [another FSA official] to) check when the last report was received and the period it related to.

In response to 10/07/2001 [14:09], the Director of Insurance says that this did not seem to provide the advice promised and, to save time, he sets out what he imagined the advice should be:

As I understand it FSA may intervene where the criterion of sound and prudent management is not met, and in particular in this case, if it appears that the company is not being managed with “due regard” to policyholder interests. Additionally the FSA may be able to act if it appears to it that the company may be acting in a way inconsistent with fulfilling PRE. These are discretionary powers and we have always taken the view that the test to be applied before using them is quite a high one. They are not designed simply to allow us to substitute our judgement for that of the company (whether on policy or legal matters). In that respect they are to be distinguished from the more absolute requirements of the Act, and the related regulations (eg on reserving standards), where we are entitled (indeed possibly bound) to act if in our opinion a company is not meeting the specific requirements imposed on it.

In the present case it appears that the company take a different view of the risk of legal challenge than we do. We know that, at our insistence, they are going back to counsel to test their original view of the legal position (as we ourselves have done). If their new opinion coincides with our own, and the directors follow it, then the problem disappears. But if counsel for the company take a different view we should not necessarily insist on the company acting on the basis of the advice provided to us rather than on their own. The advice we have been given, and the company’s intention to follow their own, and contrary, advice, would not of themselves constitute grounds for intervention action.

However there are a number of things we should do immediately. We should:

a)ensure that the [company] are aware of the views of our counsel – as a matter of urgency;

b)draw their attention, in particular, to the dangers we envisage arising in relation to the 425 scheme;

c)ask to see the Society’s opinion so that we may satisfy ourselves that it addresses the right questions, and is not obviously defective (as it might be if the instructions on which it was based were inadequate);

d)tell the company that we are reviewing the question of whether we should intervene to prevent them acting as they currently intend, and that we will decide on, and if necessary take, formal action, before their decision is due to be announced on 16 July.

Subject to a), b) and c), and provided we are satisfied that the Board has properly considered the issues in the light of (adequate) advice provided to it, and the full knowledge of our views, my firm view is that we should not insist on taking the decision for the company (which would be the effect of intervention action).

[10:48] Chief Counsel B says to the Director of GCD, Chief Counsel A and Legal Adviser D that: ‘I think that if an insurance company were to act on the basis of a legal view which we think is wrong, then the ICA intervention powers would be available. I think, however, it would be a reasonable policy decision not to do so’.

[12:04] The Head of Life Insurance agrees with the steps outlined by the Director and: ‘If we are satisfied with the steps they have taken to obtain legal advice, and in the light of all legal advice the company decide to cease applying the GAR rate to top-ups, I agree that we should not intervene to prevent that’.

[13:06] Chief Counsel A agrees.

Further to the Head of Actuarial Support’s comments of 10/07/2001 [16:00], FSA’s Insolvency Practitioner writes:

I think that we may need to develop our views on when Equitable might become insolvent in Insolvency Act terms and what action the FSA might take at that point (if it arises) and how the FSA might respond if the directors became uncertain about the Society’s solvency and whether they were wrongfully trading.

We might need the Society to report regularly and frequently the “fair” values of assets and liabilities (rather than prudent values as in the FSA returns).

However, we should not jump to the conclusion that liquidation is in any policyholder’s best interests even if the Society were marginally insolvent: ie in the short term, policyholders with benefits falling due some way in the future may be worse off in a liquidation compared to permitting the Society to pay in full benefits now falling due for payment.

Unfortunately a lot hinges on what value is given to PRE in any solvency test. As bonus rates are cut, policyholders’ expectations diminish and the excess of asset shares over guaranteed benefits becomes available to meet other liabilities (eg mis-selling claims). If I understand the latest Equitable board papers correctly there is £1,550m headroom available, after GAR provisions, to meet mis-selling claims on the 30 June 2001 worst-case projected balance sheet. We might need Counsel’s help with this issue.

The Insolvency Practitioner goes on to set out the key differences between solvency under ICA 1982 and under the Insolvency Act, these being:

• Policyholders reasonable expectations can be included in the Society’s liabilities (the court can require them to be valued in a liquidation) – this would probably result [in] policies being valued at the asset share values published to policyholders.
• Liabilities could be discounted at a fair estimate of the rate of return on all assets available to meet those liabilities: eg assumed returns on equities need not be limited to the dividend rate.
• All assets of the society can be taken into account: not just “admissible” assets.
• Resilience reserves are not liabilities which need to be taken into account.
• Implicit items in the FSA return are not taken into account, but the key test is whether the total projected cash flows from all assets and liabilities is positive at the end of the projections. These projections can take into account the profit element in gross premiums due to the society – to this extent future profits could be taken into account.
• Subordinated loan guarantees are liabilities which need to be included.
• Reinsurance cover must be included only at a realistic value (but can assume business continues)
• Liabilities arising from top-ups to GAR policies need to be included.
• Sales proceeds (the Halifax consideration) can be taken into account if there is a realistic prospect of their being received).

On liquidation other factors arise (but these need not be taken into account in any going concern solvency test – they do need to be taken into account if the society wished to be pass a members (ie solvent) voluntary winding up resolution (permissible with FSA consent after N2 [i.e. 1 December 2001, when the new regulatory regime came into force]).

• The GAR reinsurance contract terminates.
• Administration agreements with Halifax become terminable.
• Liquidation costs arise.
• Unit linked liabilities are paid by Equitable at the same dividend rate as all Equitable’s other creditors face unless (as is likely) Halifax make cut-through payments direct to unit liked policyholders and take an assignment of their rights against Equitable.
• GAR options are valued in a liquidation (and need to be similarly valued in the above solvency test).

[16:06] FSA’s Head of Actuarial Support responds:

The exact solvency margin on a Companies Act accounts basis is unclear at present (the figures in the two recent board papers being rather different). Hence, my recommendation that we should indeed request some up-to-date information on the fair value of (tangible) assets as at 30 June. However, you need to be aware that the Companies Act accounts do not include any provision for final bonuses, so that any cuts in those bonuses will not directly impact on this balance sheet.

I think we may need to discuss further the basis on which the liabilities would be determined for the purposes of testing insolvency. In particular, I am not sure about your first 2 indents on this topic. If the liabilities are taken to be the underlying policy values (without allowing for the financial adjuster that may be applied on surrenders), then we would indeed have a problem now. However, the Companies Act basis liabilities would be rather lower, and at end-2000 were I believe essentially taken as equal to the guaranteed fund (plus best estimate value of GAR’s) for most of their policies.

Arguably, as I think you indicate in your second indent, these liabilities might be discounted further at some assumed long-term rate of return (net of the 3.5% guaranteed future investment returns on most GAR policies), but then with the addition presumably of some allowance for PRE (all on the lines I think of the 1985 Winding Up Rules).

Equitable send FSA a draft of their paper ‘The Business Case for the Section 425 Scheme’. Equitable ask for a response by 16 July 2001 and say: ‘Given the tight timescales no response by that date will be taken as acceptance of the content and you have no issues with regards sign off of this document by the 20 July’.

[16:59] Line Manager E distributes the paper, commenting that he did not think that it was for FSA to ‘sign off’ Equitable’s document. He suggests that FSA should make this clear to them at their meeting the following day.

FSA write to Equitable to set out their position on the company’s plans to cease to apply annuity rate guarantees on top-ups. FSA explain that they had identified four potential problems, those being:

• There is real … difficulty in the way of trying to prevent people who have not paid or recently paid a premium from exercising top up “rights”, because of representations made when policies were sold (and possibly later);
• However, these “rights” do not have contractual force, and can be removed or changed by notice indicating that the Society is adopting a different policy, thus allowing those who have been given representations that they can top up at any time to consider whether they wish to top up now, before the policy is changed (taking into account the effect this will have on their possible rights under the GAR/non-GAR scheme);
• It might not be particularly effective in practice to make this change, because it is possible that the reason for the annual percentage reduction in exercise of top up rights is accounted for by people moving out of self employment and so losing their eligibility to participate under Inland Revenue rules;
• It is extremely important for eligibility for top up to be got right, because it could affect the votes which could be cast in the 425 scheme, and a mistaken basis for calculating these votes could allow this scheme to be set aside.

FSA say that, in the light of this, they believed that there were significant risks to Equitable in proceeding as planned without providing adequate notice to policyholders.

The reservations we expressed to the Equitable’s project team last week remain: the cost has to be higher than the £1.3bn best estimate if policyholders able to retire now or shortly are not to be worse off.

We need to know what sort of bonus policy will be followed after the scheme becomes effective; particularly how the £250m to £500m consideration from the Halifax will be distributed in terminal bonuses.

We also need to know what investment strategy the Society will follow after the scheme is effective.

We need also to ask the Society to report monthly their financial position on both an FSA return basis and a realistic basis (policy values vs asset shares). We also need to know about assets and liabilities other than those associated with the with-profits fund and perhaps we should also ask for monthly balance sheets or management accounts prepared on a Companies Act basis.

There has been (or shortly will be) a substantial change in the Society’s financial position. The scheme must therefore include an up-to-date revised balance sheet, and I think that it should be audited. I believe that the impact of the scheme on policyholders will be clearest if such a balance sheet is presented in a way which shows aggregate asset-share policy values.

The paper needs to specify how the value of policies will be calculated for voting purposes: eg guaranteed values, asset share values, full rights to GAR options, or something less? What is [Equitable’s solicitors’] advice on this?

I see a scheme adjudicator has crept in (5.15). Who is this proposed to be? Will he adjudicate mis-selling claims? Are we comfortable with policyholders’ recourse to the courts being curtailed?

FSA and Counsel for FSA meet Equitable, Equitable’s solicitors and Equitable’s actuarial advisers to discuss the compromise scheme. According to FSA’s minutes, the purpose of the meeting was to: review and comment on Equitable’s business case paper; identify any changes to the scheme methodology; and inform Equitable of the final criteria against which FSA would judge the fairness of the scheme.

Under ‘Action points’, Equitable are to provide FSA with any comments on their assessment criteria. FSA are to identify any further information required to assess the fairness of the scheme and Chief Counsel A is to revert to Equitable’s solicitors on the question of privilege.

(Note: the minutes of the meeting do not record that there was any discussion of policy value cuts, as suggested on 11/07/2001.)

Equitable send FSA a solvency matrix that was part of a paper, dated 11 July 2001, for Equitable’s Board.

The matrix sets out the ratios of available assets to minimum required solvency margin in changed conditions. (Note: ‘MV’ refers to ‘market value’).

The notes to the matrix say:

The ratio of 1.6 at 30.06.01 is after allowing for the sales of equities during June. It is also unlikely that the Society’s assets will have performed exactly in line with the indices.

The figures take account of additional reserves in respect of guaranteed annuity rate options at the level which reflects the financial reassurance arrangement and assumes the bringing into account of a “future profits” implicit item equal to 5/6ths of the minimum solvency margin. Such additional reserves will increase as interest rates decrease and so the cover ratio reduces with a fall in yields although the effect is partly offset by the corresponding increase in market values.

FSA’s Head of Life Insurance provides their Press Office with two amendments to FSA’s public statements:

1.Is the company still solvent?

Yes. We are satisfied, on the basis of the latest figures supplied by the company, that it continues to meet its solvency margin requirements. As the company has made clear in its Annual Report and in its regulatory returns, it continues to face some fundamental uncertainties.

(The point here is that we must put the confirmation of solvency in the context of the fundamental uncertainties – the company themselves do this, but far less clearly)

2.(Supplementary point on the Financial Adjuster):

Is the 7.5% level fair?

As explained above, it is perfectly reasonable to apply a financial adjuster in circumstances such as the Equitable now face. The precise level at any given time is a matter of judgement for the company. We continue to monitor the position closely, and will not [hesitate] to intervene if this would be justified.

[09:25] The Head of Actuarial Support advises:

Regarding the second point below on the financial adjuster, I believe that the position we reached with [Equitable’s Appointed Actuary] over the weekend (not for publication I would suggest) is that the 7.5% adjuster is an arbitrarily calculated adjuster that is designed to protect the fund against the effect of surrenders. As such though, it has not been reviewed against either the representations made to policyholders at point of sale or the provisions of the Unfair Contract Terms rules. [He also mentioned I believe that his own preference was for a 5% figure while [Equitable’s Chief Executive] sought 10% and they compromised on 7.5%].

The qualitative reasons stated for this adjuster (which he said were not for publication) were as follows

(1)To allow some room for manoeuvre in volatile investment conditions (i.e. to avoid frequent changes in this adjuster)

(2)To recover all their initial expenses (i.e. deferred acquisition costs)

(3)To allow for the increase in marginal costs for the remaining policies in the fund as a result of the decline in fund size

(4)To build up a reserve for the fundamental uncertainties (i.e. principally the potential mis-selling costs)

(5)General protection of the fund for remaining policyholders

My understanding is that Items (1) and (2) had previously been allowed for in the 15% MVA, but Items (3) to (5) appear to be new.

I think they will have considerable difficulty in explaining to policyholders the reason for the sharp increase in the financial adjuster from 15% to an effective 27.5% for most policies, even if they do choose to publicise the above factors.

In particular, I am conscious from figures they produced earlier that the payouts in respect of many recent policies are now likely to be less than asset shares, even without the 7.5% financial adjuster, thereby exacerbating potential mis-selling claims.

[10:05] The Director of GCD states that the advice already given by FSA’s legal department was that, from the viewpoint of the Unfair Terms in Consumer Contracts Regulations 1999, it was necessary for Equitable to establish clear binding public criteria for the level of market value adjuster applied, so that policyholders could not be subject to arbitrary and unilateral changes of approach. The Director of GCD says: ‘My worry about these new criteria would be that 5 is completely open ended and that the changes in the criteria do not seem to justify the new values given’.

[10:30] The Head of Life Insurance informs the Director of GCD, the Head of Actuarial Support and the Head of Press Office that he had received a separate explanation from Equitable, being:

1.Overarching point; fairness between leavers and stayers. But with the benefit of any doubt (“priority in fairness”) given to stayers;

2.Market values; when markets are volatile, there is a need to have bases for both maturity and surrender which can be set for a reasonable period; and a fair level for “market value” should be more conservative for surrenders than for maturities;

3.Expenses; recovery from early surrenders;

4.Uncertainties: Uncertainties have to be allowed for, but should be allowed for on a more conservative basis for surrenders than for maturities (comment; this can perhaps be justified on the basis that surrenderers have discretion over timing of withdrawal, whereas maturing policies do not. This is I think a bit less open ended than point 5 below).

[10:40] FSA’s Head of Actuarial Support notes that Equitable still had the difficulty of explaining why surrender values had decreased so sharply and suddenly, while FSA had the difficult question to consider as to whether the Society’s policy was fair to departing policyholders and consistent with the representations which had been made to them.

FSA’s Director of GCD provides the Director of Insurance with details of a discussion that had taken place on 13 July 2001 with Counsel about mis-selling liabilities. This had followed a discussion earlier that day between FSA and Equitable’s lawyers.

The Director of GCD reports: ‘In short, their view was that the relevant Lautro rule required disclosure of the GAR liabilities from the point at which a policyholder might reasonably expect that they would affect the amount available for distribution by way of bonus’.

The Director of GCD says that Counsel had considered whether any action by Equitable to mitigate the impact of annuity guarantees (for example by using reinsurance, financial hedging instruments or the differential terminal bonus policy) would affect policyholder expectations. Counsel’s view was ‘that policyholders would indeed expect that liabilities which should be disclosable, but for mitigation of this kind, would remain disclosable’.

The Director of GCD says:

The effect of this was that:

• the GAR liabilities were disclosable from the point at which their size, having regard to the company’s assets, were such that policyholders might reasonably expect that they would affect the amount available for distribution by way of bonus;
• in determining this, the society’s arrangements for mitigation of the size of the liabilities by way of the differential bonus policy should be left out of account;
• there was no sense in which this involved interpreting the rule to require people to disclose, retrospectively, what the court subsequently decided.

My view is that this is a sustainable interpretation of the Lautro rules, and the one which the courts are most likely to adopt.

It remains possible that the actual liabilities of the Equitable for misselling are greater than those which would be produced on this basis. We understand that [Counsel for Equitable] takes the view that the GAR liabilities were disclosable from the late 1980s, on the basis that the society was aware, even then, of their potential impact. Though we do not accept this as the correct interpretation of the Lautro rule, we cannot discount it without seeing his opinion and the facts on which it is based.

FSA’s Chief Counsel B and Legal Adviser C provide advice on the operation of the compensation scheme under the Policyholder Protection Act and under the new rules to come into force on 1 December 2001 with the commencement of the majority of FSMA 2000.

[15:15] The Director of Insurance asks whether the position outlined was ‘a little more definite than is justified as regards the Equitable’, saying that he was not sure, given the advice they had received, that compensation from the Policyholder Protection Board would be payable. The Director says that FSA should be pretty circumspect in what they said, as he ‘would not wish to get into a position where it might be thought that we had promised more than could be delivered’.

[15:18] The Director of GCD agrees with the Director of Insurance’s comments.

[15:35] FSA’s Press Office circulates the advice and [15:59] later confirms that the Director of GCD had since clarified that FSA: ‘can be quite firm on the negative aspects of the [Policyholder Protection Board]. The compensation scheme would not cover terminal bonuses before the company has formally decided to award them, so there can be no question of policyholders being worse off now than if the company had been wound up in December – contrary to what some of the policyholders’ groups are suggesting’.

FSA’s Chief Counsel B asks Line Manager E what was happening with regard to correspondence about the market value adjuster issue.

[16:15] Line Manager E replies:

At some point I think I will mention to Equitable that we have taken over the files and that as they are aware of our corporate view, which we have exposed publicly (eg via the website), we are not proposing to take the matter further [for the time being]. But I will remind them it is something we are looking at mvas generally in the context of the with profits review. I reached the view that if I tried to press the [unfair terms in consumer contracts] team to write in response to the Equitable offer to OFT, there was a chance it would reopen the substantive debate.

Chief Counsel B later forwards the correspondence to the Director of GCD, who comments: ‘Not sure this decision will prove to be sustainable’.

FSA’s Scrutinising Actuary F advises Line Manager E that FSA should request from Equitable the details of the Appointed Actuary’s prospective calculation for their application for a section 68 Order for a future profits implicit item for possible use in the 2001 returns (see 28/06/2001 [entry 2]). The Scrutinising Actuary says that they would need to see details of:

• the method and the actuarial basis he has used for the prospective calculation, including in particular the assumed rate of future investment return, and
• the allocation of the anticipated future profits as between the implicit item sought, any obligations the Society will have under the GAO reassurance treaty with Irish European, its ability in respect of the subordinated loan, and any other call on these monies which is envisaged.

Scrutinising Actuary F also says that it would be helpful to see these details in respect of the ‘number of other calculations’ referred to in Equitable’s application. He goes on to say: ‘We recall that the Society were asked to supply this information in respect of the implicit item used in the 2000 Returns – we do not recall ever seeing this information, and suggest it is requested again. We can then review both sets of calculations together’.

FSA’s Chief Counsel A provides the Director of GCD with a list of the ‘big areas’ for the compromise scheme proposals where FSA could not yet be satisfied due to insufficient information or justification, or because they did not believe it to be fair. She states:

1.I think we are agreed that the proposed treatment of those reaching retirement age within (say) 3-5 years from the effective date of the scheme is not fair. We might be able to agree to a proposed taper up to 75% of the economic value of the GAR rights (in the case of those reaching 50 very soon after the effective date) on the basis that almost everyone in practice takes the 25% cash lump sum. This is a little uncomfortable because it is to insert into an evaluation of individual rights a value based on the experience of the group, but it is a rough and ready “justice” which we might consider acceptable.

2.The calculation of the up-lift for premium and non-premium is still a mess. Some improvement may follow on from whatever the Equitable decides to do on receipt of its legal advice on top-ups. At the moment, apart from the issue of whether the Equitable can include as non-premium paying those whom it is planning to cut off without notice, there is an issue as to whether Equitable can treat as premium paying those whom it has not cut off whom it could have cut off. I am also concerned that the Equitable is valuing top-up rights on the basis of historical experience. This is the accepted actuarial method (as we heard from [Counsel for Equitable] on Friday), but I remain to be convinced that we should not be using a different methodology to calculate economic value (and one that does not rely on the experience of the group).

3.Finally, although the figures may be around now (and I have just not caught up with them), we have some concerns that the 3% up-lift for pre-1975 policies may be operating unfairly within the group.

Chief Counsel A concludes that she thinks FSA ‘can say now that subject to the up-lift operating fairly (on the basis, mainly, of the value of individual rights, not the experience of the group, and other caveats like misselling and the possibility of submissions from policyholders in due course which may cause us to change our mind), calculating the pot on the basis of the cost of the GARs appears to be reasonable. On the up-lift, however, while I think we are heading in the right direction and we have no reason to think Equitable will not find a solution which we can accept, we are not there yet. This message may still be positive enough for the Equitable to be getting on with’.

FSA’s Director of Insurance writes to the Director of GCD (copied to others) suggesting that a ‘core group’ is established to co-ordinate work on Equitable. The Director identifies a number of issues that FSA needed to address in the following areas:

• compromise scheme;
• financial position;
• mis-selling;
• availability of compensation;
• contingency planning; and
• FSA decision making.

HMT ask FSA for answers to some questions raised by the Economic Secretary to the Treasury. The questions are:

1.What did the FSA say at the time the Halifax deal was announced? How did you frame your comments on the wisdom of staying in or leaving the fund? Have you said anything since? What was the basis for commenting on the deal at all?

2.Do you consider saying anything about yesterday’s announcement? Did you consider urging [Equitable] to make it sooner, or saying something yourselves beforehand?

3.What is the basis for your current assessment that [Equitable] is solvent? Does yesterday’s announcement have any bearing on this? Does it increase the risk of members leaving and thus worsen solvency? And what about the likely publication of Counsel advice on misselling? How great is the risk of insolvency, and what do we do then?

4.Had Equitable’s funds been revalued between December and yesterday’s announcement?

5.How does the size of yesterday’s revaluation compare with market movements generally over a directly comparable period?

Following the Equitable Life Lawyers Group meeting the previous day, Legal Adviser A asks Line Manager E and the Head of Life Insurance whether FSA should impose a notice of requirements on Equitable for the provision of regular updates of their financial position, verified by their auditors. He says that he understood that FSA currently received monthly updates.

[12:50] Line Manager E says that he was not sure that the monthly reports were ‘capable of audit’. The Line Manager also confirms that FSA ‘are supposed to get monthly reports, but they have not been doing very well of late – the last we had was as at end March. I have it on my to-do list to raise this with [Equitable’s Appointed Actuary]’.

FSA’s Press Office asks the Head of Life Insurance whether someone had already suggested to Equitable and/or the Society’s Chairman that they did not make misleading statements ‘such as that their cut in policy values was not done for solvency reasons? Obviously this is stretching the truth somewhat, and [although] we can’t take away the fact that he said it, he presumably shouldn’t be saying it again given what we know is in their annual return? If we say nothing they will probably treat it as acquiescence?’. The Press Office also suggest that Equitable might be misleading people about the benefits of switching from equities to bonds.

The following day, the Head of Life Insurance says that the Press Office’s first point was well taken but that he was not sure about the second.

FSA’s Director of GCD replies to Chief Counsel B’s note of 17/07/2001 [15:12], saying:

I misread your note and believed we were in agreement. As I understand it you conclude that the [Policyholders Protection Board] can pay compensation on an amount which includes PRE. If this is right, it applies to the future as well as the past and means that people might indeed be better off on a liquidation than accepting what the [Equitable] offers them. It also suggests that this is the answer on [Article] 4 – ie that you can get back not only the reduced value of your [liabilities], but also 90% of [policyholders’ reasonable expectations] so perhaps in some scenarios liquidation would give people more back … we need to evaluate this.

(Note: the Director of GCD replies again to this query on 24/07/2001 [11:33].)

[13:04] The Director of Insurance writes to the Director of GCD and Chief Counsel B saying that, as they had agreed that morning, ‘this is of potentially very great significance’. FSA are to commission advice on how a court might determine policy values having regard to bonus expectations.

[14:12] FSA’s Insolvency Practitioner informs the Director of Insurance, the Director of GCD and Chief Counsel B that the case of another company that had gone into liquidation was not particularly helpful. [14:18] The Director of Insurance thanks him and says: ‘So at least we know that we are in uncharted waters’.

FSA and PIA meet to discuss the regulatory control of Equitable following the Director of Insurance’s note of 17/07/2001. FSA’s note of the meeting records that no meetings were to  take place without the prior knowledge of the supervisory team and, whenever possible, supervisors should be invited to attend. The note summarises the discussions on a number  of issues.

Financial position

FSA say that Equitable’s Chairman’s most recent statement regarding the solvency of Equitable was arguably misleading. It is agreed that FSA should issue a Notice under section 44 of ICA 1982 requiring the Society to provide monthly financial information and to demonstrate that it was solvent under the requirements of both ICA 1982 and the Companies Act 1985. It is also agreed that there should be an independent review of Equitable’s financial condition within three to four weeks.

(Note: on this last point, the draft minutes of the meeting read: ‘It was agreed to appoint an independent auditor (probably [Equitable’s new auditors]) to report to the FSA on the solvency of the Equitable within 3-4 weeks’. On 19 July 2001 (at 15:14), Managing Director B writes that he ‘thought we agreed that the independent audit should not be done by the Society’s auditors (i.e not [Equitable’s auditors])’. The final minutes are amended to read: ‘It was agreed that there should be an independent review of Equitable’s financial condition within 3-4 weeks’.)

Mis-selling

The note records that the following actions were agreed:

• that Counsel should be asked to produce provisional advice on mis-selling.
• that FSA should ask Equitable formally about their strategy for pensions mis-selling claims on publication of their Counsel’s opinion.
• that FSA did have powers to stop Equitable publishing their Counsel’s opinion but that it was unlikely to be in the interests of policyholders to exercise those powers.
• that FSA should ask Equitable about their ability to reserve for mis-selling claims. It is noted that work would be needed to quantify claims and that Equitable would need adequate contingency planning to cope with a range of possible outcomes.

Compensation – Policyholders Protection Board

FSA note that the Court would probably include policyholders’ expectations in calculating policy values in the event of liquidation and the Policyholders Protection Board would pay 90% of policy values after determination by the Court.

Compromise scheme

It is agreed that FSA could not sign off the current proposed compromise scheme until it was clear how those proposals ‘measured up’ to their criteria. FSA record that the scheme would be ‘arguably unfair … if it did not include pensions misselling claims’. FSA also record that Equitable should be asked to justify the advantages of a compromise scheme over the status quo and formal Insolvency Act procedures.

Contingency planning

FSA record that administration, if it were extended to insurance companies, would be preferable to provisional liquidation. The Director of Insurance agrees to talk to HMT about the possibility of an Order being made under section 360 of the FSMA 2000 (Note: this was commenced on 20 July 2001 and gave HMT the power to make an order to allow insurance companies to be placed into administration).

Further action points

The following items were noted for further consideration:

(a)The FSA to require Equitable to freeze payments of terminal bonuses.

(b)The FSA to require the Equitable to move further funds from Equities to Gilts. The ratio was currently 61.5%. (We have now been advised that equity proportion is 48%, 12% property and 40% bonds.)

(c)The FSA to require the Equitable to apply the MVA to terminal bonuses and not guaranteed bonuses.

(d)The FSA to seek Equitable’s confirmation that those policyholders who withdrew shortly before the announcement of 16% reduction in terminal bonuses would allow such policyholders to withdraw at the old values.

Of these (a) to (c) should be kept under review. (d) should be actioned.

FSA provide HMT with answers to the questions they had raised the previous day. FSA state:

1.Since the announcement of the closure of Equitable Life to new business, the FSA has been careful in its information to policyholders not to give them encouragement to stay with Equitable Life or to transfer to another provider. We have however encouraged people to consider any action they propose to take carefully and encouraged them to take proper advice where appropriate. We also sought to alert people to the fact that there might be downsides to their transferring, for example because of taxation or if they had GAR policies. Our position has been reflected on the website (copies of the relevant pages attached) and that neutrality has not fundamentally changed in the period since December 2000.

2.We considered carefully whether it would be helpful for the FSA to make an announcement in parallel with that from Equitable Life. We concluded that there was nothing that we wished to say proactively since this was an announcement by the company. However, we prepared lines to take in response to enquiries and were in close touch with the company to review the proposed terms of its statement to ensure that it was appropriately expressed. The announcement was made as soon as practicable after the board had decided on its course of action, so an earlier announcement was never a possibility. It should also be remembered that part of the reason for the need for such extreme action was the continuing decline in the financial markets at a time when Equitable Life policies were continuing to attract notional annual growth of 8 per cent taking the value of the policies and the assets further out of line.

3.We are satisfied, on the basis of the latest figures supplied by the company, that it continues to meet its solvency margin requirements. As the company has made clear in its Annual Report and in its regulatory returns, it continues to face some fundamental uncertainties. It is difficult to judge whether this will increase policyholders propensity to leave. The opportunity of suffering the financial adjuster at the lower rate of 7½ per cent will probably be attractive to some, but others may consider that the damage has already been done and that they would do better sitting tight. There is the likelihood of further announcements about the performance of life funds in the near future and this may discourage people for the time being.

There are however uncertainties, including in relation to the opinion on mis-selling which is due shortly (the FSA is also doing work on this topic). Subject to those uncertainties, at this stage, we do not think insolvency likely and we have been assured by the appointed actuary that there are further steps the company can take to avoid that, such as by cutting terminal bonus further. This is something that the FSA will be investigating further with the appointed actuary as a matter of urgency. If however insolvency was unavoidable, this would trigger the operation of the Policyholders Protection Act where the Policyholders Protection Board would in the first instance seek to secure a transfer of policies to another insurer. It would be able to provide financial assistance to achieve that. Alternatively, the business could be placed in liquidation and policyholders would be paid compensation up to 90 per cent of the guaranteed value of their policy at the point of liquidation.

4.The Regulations require the assets and liabilities of an insurance company to be under constant review. The movement of the value of the assets and liabilities over the first six months of the year has therefore been fairly clear and was reported by Equitable Life to the FSA on a regular basis.

5.The adjustment to policy values, as compared with the year end position, was of 16 per cent. The FTSE 100 closed at about 6220 on 31 December 2000; on 17 July 2001 it closed at 5430, a fall of about 13-14 per cent. However, at the year end, policy values were already some way ahead of the value of the underlying assets because of the continued application of an 8 per cent interim rate of return. The overall effect is to reduce policy values to close to the value of the underlying assets at the present time.

FSA’s Chairman, Managing Director B, Managing Director A, Director of Insurance, Director of GCD, Head of Life Insurance and Head of Press Office meet and agree:

• That the Society’s Board should consider [Counsel’s] opinion and the strategy for the section 425 compromise before publishing the opinion.
• That the FSA should commission a comparison by consulting actuaries of the value of Equitable policies (by type and by year) and the average value of comparable products available from other providers. This would provide, very roughly expressed, the test we anticipate will be proposed by our Counsel to establish loss where misselling is established. The quantums should be calculated against both the [Counsel for Equitable’s] and [Counsel for FSA’s] opinions.
• That the FSA should require the Society to commission an independent review of its financial position with terms of reference to be agreed with us.
• That this work should be taken forward in as timely fashion as possible to minimise further delay to the Society’s section 425 proposal (it was noted that the original immediate timetable was clearly now unrealistic). It was further noted that we would find it difficult to advise on the fairness of any section 425 scheme absent this information.
• That these points should be communicated to [Equitable’s Chairman] at a meeting the following morning.

FSA meet Equitable’s Chairman to discuss their position on mis-selling claims and Counsel for Equitable’s opinion, which was to be provided to FSA shortly. The meeting is held at FSA’s request. FSA’s note of the meeting records that discussion took place on the differences of the provisional views of Counsel for Equitable and Counsel for FSA and the immediate issues that needed to be addressed as a result of the views expressed by Counsel, those issues being:

i. Should these liabilities be brought within the ambit of the s425 scheme (our current understanding was that the Equitable and its advisers did not plan this)?

ii. Did the Society remain solvent so that it was proper for it to continue in operation?

iii. Was there a danger that the liabilities attributable to mis-selling might outweigh the value of the GARs and, if so, how did that impact on the proposed scheme?

It is noted that Equitable were to receive Counsel’s draft opinion the following day and that it would be considered by the Board on 25 July 2001. The Director of GCD informs Equitable’s Chairman that Counsel’s advice on the compromise scheme now suggested that it would be possible to include mis-selling liabilities within the scheme.

FSA anticipate:

a) That we should commission a report by consulting actuaries which would seek to establish the range of prudent liabilities [for mis-selling costs] to which the company might be exposed. This would need to involve, on the basis of what we expected our Counsel to advise, comparison of the value of Equitable policies (by type and by year) against the industry average for comparable products.

b) That there should be a rapid independent review of the financial condition of the Society. I explained the basis on which we envisaged this would be carried out – essentially that the emphasis would change from a statutory value under the Insurance Companies Act which was the focus of our normal supervisory attention, to one based more directly on Companies Act requirements.

It is agreed that there should be further discussion over these two financial reviews.

Equitable’s Chairman is ‘non-committal’ about the implications of possible mis-selling claims on the stability of the fund. FSA’s note records:

There must be some danger that policyholders – particularly non GARs – might conclude they had had enough and should leave. But there would be substantial costs to them in this (and to the Society which would need to liquidate assets to meet surrender payments further reducing the value of the Society’s assets). Much would depend on the Society’s success in marketing the proposed scheme.

Equitable’s Chairman, in response to FSA’s Chairman, says that there was no sign that the directors might be unwilling to continue.

FSA’s Line Supervisor C sends the Director of GCD copies of FSA’s letter to Halifax of 31/01/2001 and PIA’s letter to Equitable of 31/01/2001. The Line Supervisor says: ‘I got this message second hand so I hope this is what you need. I don’t think we gave a positive undertaking not to reveal this – but I presume it was implicit that this was confidential communication between the regulator and a regulated firm’.

[14:41] Line Manager E comments: ‘I think it was understood that the fact of possible disciplinary action being dropped, and the reasons why it happened, would at some point become known. I think there was also, however, an understanding that we would not reveal the information just for the sake of it. If the reason for the question is connected to the Review, I think that that is precisely the kind of situation where it was envisaged that some form of disclosure would happen’.

FSA meet Equitable’s Appointed Actuary to set out what financial information they would want to receive on a regular basis to enable them to monitor effectively Equitable’s ongoing financial position. FSA’s Head of Life Insurance’s note of the meeting does not state what information was required; however, it does state that Equitable’s Appointed Actuary had no problems with the request and that FSA had explained to him that they would want to translate the request into a formal requirement.

FSA also outline the ‘additional steps’ they were minded to take (i.e. an independent review of the financial position of the Society), as discussed with Equitable’s Chairman that morning. In response to this, the Appointed Actuary says that if this were to happen his position would become untenable and that he would have to resign. The Head of Life Insurance’s note goes on: ‘[The Appointed Actuary] already has plans to call on the resources of [his company] to undertake work to validate the financial position. He would not want to commit to this if FSA were to require another firm to be brought in’.

The Head of Life Insurance comments:

I think this puts a different perspective on our discussions yesterday about the identity of a firm to carry out the work envisaged. For the Society to lose another Appointed Actuary at this delicate stage would be a very serious, and potentially fatal, blow. As regards independence, I think it should be acceptable for the Equitable to commission [the Appointed Actuary’s company], if it was made clear that the commission was to the firm, as distinct from [Equitable’s Appointed Actuary], and that [the company] would have a duty of care to FSA as well as to the Equitable.

[15:16] The Director of Insurance responds to the note of the meeting, saying that he agreed with the Head of Life Insurance that there could be ‘awkwardness’ if Equitable’s Appointed Actuary resigned, but adds ‘I am not sure we should let him use this to prevent us from doing what we think is necessary’.

[19:23] The Head of Life Insurance replies to those comments, reporting that he had received a telephone call from the Appointed Actuary’s company and one from Equitable’s Chief Executive. The company had expressed concern at what the Appointed Actuary had reported to them and stressed that: ‘[The company] had recognised the risks to them as well as to [the Appointed Actuary] personally in agreeing to make him available as the Appointed Actuary of the Equitable and saw themselves as standing behind [the Appointed Actuary] to provide additional resource and expertise, and independent and objective review of his actions and assessments’. The Head of Life Insurance says that he explained FSA’s reasoning that ‘in the special circumstances of the Equitable, it was reasonable for the regulator to take additional steps to satisfy itself about the financial position, including commissioning (or asking the Society to commission) independent work’. In response to the Appointed Actuary’s company arguing that they should be considered as being independent, the Head of Life Insurance states that FSA ‘were likely to take the view that these advantages [regarding efficiency and minimising the strain on Equitable’s resources] were outweighed by the extra independence that would be provided by involving a third party’.

On the conversation with Equitable’s Chief Executive, FSA’s Head of Life Insurance says that the Chief Executive had been in an ‘emotional mood’ and had said that ‘if the FSA wanted to run the Equitable, then they were welcome to do so, and he would join [Equitable’s Appointed Actuary] in resigning’. The Head of Life Insurance says that he had stressed that ‘although what we were proposing was unusual by the traditions of DTI/HMT insurance regulation, it was perfectly normal in the context of banking supervision, and as an integrated regulator, it was natural for the FSA to review the full range of supervisory tools available (and familiar) to it’.

[15:44] The Head of Actuarial Support writes separately to the attendees of the meeting, pointing out that the Appointed Actuary was a consultant from an actuarial firm rather than an Equitable employee. The Head of Actuarial Support provides eight key points from the meeting, those being:

1)For the Companies Act accounts at 30 June 2001, Equitable’s Appointed Actuary believed assets exceeded liabilities by £1.6bn, ‘Therefore, a provision for mis-selling would take them right up to the line’. He says that he believes that Equitable might be able to justify reducing their liabilities by £400m to £800m but that the Head of Actuarial Support had reminded him of the ‘professional responsibility to take particular care in selecting an appropriate actuarial basis when the solvency of an insurer is in doubt’.

2)Equitable do not appear to have considered the possibility that redress for mis-selling might need to be calculated on the basis suggested by Counsel for FSA.

3)In the event of a provision for mis-selling of £1.5bn being required, the Appointed Actuary’s view was that the Board would wish to consider freezing all final bonus payments and further increase the financial adjuster applied to surrenders.

4)Equitable’s asset mix is currently 48% equities, 12% property and 40% bonds. They were trying to sell around £600m to £800m of equities each month in order to fund cash outflows and to reduce their holding in equities by 5% over the next three months.

5)Equitable’s Appointed Actuary says that he believes that there would be no scope to increase the proportion of assets held in equities as a result of the compromise scheme and ‘Accordingly, any such references were being removed from the documentation’.

6)Work on the compromise scheme was continuing without any modifications to allow for Counsel’s opinion on mis-selling.

7)The Appointed Actuary confirms that recent policies where policy value was less than the guaranteed fund would not receive any final bonus. The Head of Actuarial Support asks him to consider ‘whether the policyholders were sufficiently aware now of the society’s present investment policy and how this might affect their future bonuses in variable investment conditions’.

8)FSA present the Appointed Actuary with their draft proforma for monthly financial reporting that FSA were likely to make into a formal requirement.

FSA’s Head of Actuarial Support sends Chief Counsel B a note summarising his research on the claim values currently being paid by Equitable for pension policies written in 1996, hoping that it would be helpful to Counsel’s analysis. The Head of Actuarial Support notes that, while some further work would need to be done to determine the potential redress for individual policyholders, ‘we should be able to make some broad estimate of the potential provision that may be required if this is the likely approach, once we have some idea of which generations of policies are likely to be affected. For example, if this were to include all policies written since 1988, then we could be looking at a provision of around £4-5 billion’.

[18:26] The Head of Life Insurance questions why Counsel needed this information.

[18:42] FSA’s Director of Insurance suggests that it is needed not for quantification, but to form a view of the date from which mis-selling occurred.

FSA complete their Initial Scrutiny of the Society’s 2000 regulatory returns.

FSA complete Form A2, which follows a similar format to that used for the 1996 to 1999 returns and includes the following:

Strength of valuation basis

FSA note that the rates of interest used for with-profits business do not appear to make provision for policyholders’ reasonable expectations and comment: ‘Form 57 @ 4% used in respect of [pension business] valued at 3¾%’. FSA note that other management expenses, at £80m, are material. FSA confirm that Equitable have applied the resilience test in accordance with the latest published guidance (see 15/05/2000). FSA judge the overall interest basis and, taken overall, the valuation basis appears to be ‘adequate’ to ‘weak’.

Solvency position

FSA judge the absolute level of cover for the required minimum margin to be ‘of concern’. FSA observe that the trend in the level of cover over recent years has been ‘down’ and that the slope of the decline is steepening.

Suitability of assets

FSA note that the level of mismatching by currency is material and comment that there were insufficient sterling assets. FSA also note that linked asset surpluses/deficits were material but were less than 1% of unit values in aggregate.

Operating results

FSA answer ‘yes’ to the question ‘Is either the absolute level of surplus/deficit emerging or its trend over recent years such as to give current cause for concern?’. They again note that the amount of reinsurance is material and that there was a material exposure to non-UK authorised reinsurers without deposit back.

PRE issues

FSA identify no issues of concern.

Current issues

FSA note that Equitable have set up an identifiable reserve of £130m (£132m in the 1999 returns) in respect of pensions mis-selling. FSA again state that Equitable were known to have material exposure to annuity guarantees and that either the amount of the additional reserve, or any aspect of the basis used to calculate it, was a cause for concern.

FSA do not make any ‘General comments’ and they maintain the priority rating at 2.

FSA also prepare a five-page report on their initial scrutiny.

FSA state that Equitable’s solvency position was very weak and, despite strengthening of the valuation basis in the 1999 returns, ‘areas of weakness appear still to remain’. FSA say that the position is obfuscated by Equitable reporting only a bonus reserve valuation without the appendix net premium valuation. Their primary concerns relate to the adequacy of the reserves for accumulating with-profits business and of the provision for future expenses.

FSA produce a table of Equitable’s financial position which shows that available assets have fallen from £3.86m for the 1999 returns to £1.63m for the 2000 returns, resulting in a fall in their cover for the required minimum margin from 3.46 to 1.34. FSA say that available assets have fallen dramatically as a result of:

• increased reserving for GAO’s,
• changes made to the valuation bases as a result of correspondence with GAD in late [2000] following our scrutiny of the 1999 Returns,
• the impact of the 2000 (Amendment) Regulations introduced in May 2000, and
• the poor investment returns experienced by the fund over the year 2000. (The Report & Accounts quote a total return of +2.7% on the fund over the year, which was in fact quite good relative to the performance of the markets, and the results achieved by competitors.)

FSA note that the solvency position improved in March 2001 with the sale to Halifax ‘although the position remains tight’.

FSA explain why the reserve for annuity guarantees had increased from the previous year. They set out the level of reserve as being:

(£’000s) 31.12.2000 31.12.1999

Gross 2,631,000 1,663,000

(Reassured) (808,000) (1,098,000)

Net 1,823,000 565,000

FSA say that the higher gross reserve reflects: reductions in the yield on fixed interest securities; the impact of the 2000 (Amendment) Regulations; and a strengthening of the assumed future mortality assumption. FSA explain that the reinsurance offset was lower due to renegotiation of the treaty following the House of Lords’ decision.

FSA set out the changes to the valuation basis resulting from their scrutiny of the 1999 returns, which were:

• An increase in the assumed GAR take-up rate from 85% to 90%. (FSA note that information on the assumed take-up rate had not been specified in the returns but had been advised in Equitable’s letter of 16/11/2000.)
• A reduction in the rate of decrement assumed for future premiums paid on policies containing guaranteed annuity rates.
• A reduction in the assumed retirement age from 55 to 50.
• The effects of the synthetic bond which required Equitable to aggregate the rates of interest on fixed interest securities.
• Discontinuation of the use by Equitable of a zillmer type adjustment in the resilience scenario. FSA note that, while this issue appeared to have been resolved, ‘the overall approach to reserving in the resilience scenario at this valuation appears to be weak, and we are questioning this in our letter’.

FSA highlight the additional statements of uncertainties included in the 2000 returns. Those were made regarding:

• The review of the sale of Managed Pension policies; the unknown outcome of enquiries by regulatory and professional bodies and any actions which might result from these; no provisions for contingent liabilities had been made; and the future premium pattern of in-force policies.
• Matters relating to the certificates of the Directors and Appointed Actuary.
• The Appointed Actuary’s certificate which had been signed ‘subject to the uncertainties and limitation set out’ and which mentioned the need to adjust policy values and ‘take action on’ bonus policy.
• The Auditors’ report, which also mentioned the ‘fundamental uncertainties’. FSA note: ‘although their opinion is “not qualified in respect of the above matters”’.

FSA explain that Equitable had on this occasion only presented a bonus reserve valuation but had (at paragraph 8(d) of the returns) demonstrated that the reserves held were at least as great as a net premium valuation would require.

FSA note that the resilience reserve required had increased from £1,350m for the 1999 returns to £1,390m for the 2000 returns.

FSA explain that the amount of resilience reserve held in this set of returns is not directly comparable to the reserve held last year in either the gross premium or net premium valuations. They state: ‘This is because the underlying valuation this year is a bonus reserve valuation, but the resilience reserve held in last year’s [bonus reserve valuation] was a balancing item such that the total reserves held in both the  [bonus reserve valuation] and the [net premium valuation] were the same’. They go on to say that the resilience reserve ‘looks low’ and ‘an initial examination of Forms 57 in the 2000 Return indicates that on some of the classes of accumulating with profits business, reserves are being released in the resilience scenario, and this suggests that reserves in that scenario may be less than PRE surrender values’.

FSA note that reserves for expenses were up sharply but that it was not clear that the total reserve would be sufficient.

FSA state that Equitable’s sterling denominated assets were now less than their sterling denominated liabilities, by around £2.5bn.

FSA say that it was not clear where the reserves for the rectification scheme were held.

FSA say that an area of strength in the valuation was the general reserve of £150m, but FSA add that: ‘Whether this is sufficient remains to be seen!’.

FSA attach a copy of their letter to Equitable (see below).

FSA write to Equitable’s Appointed Actuary with some questions about their 2000 returns which had arisen as a result of FSA’s initial scrutiny of those returns. They ask:

1)How the reserves held for accumulating with-profits contracts compared with the smoothed asset shares. They ask for separate figures for products with and without guarantees (being both guaranteed investment returns and guaranteed annuity rates).

2)What amounts were generated by the valuation to cover expenses for future years.

3)To advise on any allowance made for mismatching by currency.

4)To confirm the provision held in respect of the GAR rectification scheme.

5)To provide details of the calculations to support the use of the section 68 Order for a future profits implicit item. FSA note that they did not appear to have received a reply to their letter of 12/03/2001 on this issue.

6)To explain their preferred approach to dealing with the synthetic bond, as: ‘It seems to us that there is a choice for the future – either to proceed on a basis that is consistent with the year end 2000 or to move to the alternative method you had proposed in your application that would bring Equitable into line with other companies’.

Equitable reply to FSA’s letter of 19/07/2001 about their 2000 returns. Equitable provide the following responses, as per the numbering used by FSA:

1)Equitable attach a table setting out the data on the reserves held for accumulating with-profits business (in the base and resilience scenario) and the smoothed asset share as at  31 December 2000.

Equitable say that there had been a degree of estimation in the figures for smoothed asset shares and that they would supply a breakdown of those with and without annuity guarantees next week.

2)Equitable explain their approach to the reserves established for expenses.

3)Equitable say that they had assumed that the fall in value of equities in the resilience test contained an element for mismatching by currency.

4)They provide information about where in the returns they had made provision for the rectification scheme.

5)Equitable enclose a copy of their letter and calculations dated 28/06/2001 for the future profits implicit item.

6)Equitable say that this needed to be discussed and some further work carried out. They ask to defer this item for a short period.

Equitable enclose their estimated solvency positions for April, May and June 2001 and apologise for not sending them earlier. These show:

Solvency position at 30 April 2001

Solvency position at 31 May 2001

Solvency position at 30 June 2001

Equitable conclude by saying:

Last week I sent you our “ready reckoner solvency” matrix. Using this type of methodology we estimate the statutory solvency position daily and at the low point of the market at around lunchtime on 19 July 2001 when the FTSE 100 stood at 5320 it is likely that the cover ratio was about 1.0, i.e. just covering the required minimum margin. As discussed, and is clear from the matrix further equity market falls could lead to the required minimum margin being breached.

Following a request from the Chancellor, FSA send HMT a note on Equitable, which reads:

1.Since the House of Lords’ judgement and the Equitable’s decision to put itself up for sale, the FSA’s aim has been to achieve the best result for Equitable policyholders in a difficult set of circumstances.

2.Following the Society’s failure to find a buyer and the closure to new business in December 2000, our strategy has been to:

• assist the sale of the underlying business to secure the highest possible value for policyholders;
• see new directors and new management in place;
• ensure that the Society remains solvent;
• ensure that policyholders were kept informed, both by encouraging the Society to improve its communication and by putting out our own messages through the press and on our website;
• promote a resolution of the outstanding difficulties through a compromise between the various groups of policyholders which would cap the outstanding GAR liabilities, and allow the Society to revert to a more normal investment strategy going forward; and
• address potential regulatory issues, principally whether there was mis-selling which might require compensation.

3.This strategy remains in place. The Halifax deal produced additional funds of £500m with a further £500m potentially available in the event of a successful resolution of the GAR/non GAR problem. A strong new Board is in place – albeit with thin management support. The Society continues just – to meet its margin requirements but has had to take and announce difficult decisions on the adjustment of policy values. Policyholders have been provided with relevant information, although the Society struggles to deal with the volume of enquiries and its handling of public communications has failed to win policyholders’ confidence.

4.However, the future remains uncertain.

• The Society’s solvency position remains tight and current market conditions are unhelpful.
• The compromise scheme is being worked on; the main outstanding issue is whether and if so how to incorporate the potential liability for mis-selling. Equitable have commissioned [Counsel] to advise them; his opinion is likely to be that mis-selling took place from 1988 onwards. The FSA has commissioned its own advice which is not so extreme, but is expected to be that there are significant liabilities for mis-selling, dating broadly from the point at which the annuity rate guarantees became valuable, as long term interest rates fell.

5.Against this background, the strategy is still feasible, but will be difficult to achieve. [Counsel] is briefing the Society’s directors today but his final Opinion is two weeks away. Meanwhile the Board will consider its response, and the implications for a compromise scheme. We are liaising closely with the Society over this. We believe that the best solution would be to include any mis-selling liabilities within the compromise. This will be a complex task. It may not be possible to meet the 1st March 2002 deadline set by the Halifax as a condition for putting up to £500m extra into the Equitable’s fund.

6.It is for the Society to bring forward proposals for a compromise; but the FSA needs to be in a position to take its own view on the fairness of any proposal (we need to satisfy ourselves that we should not intervene to prevent it on the grounds that the Society is not acting in the interests of policyholders) and we will wish to make our position clear to the Court, which will have to decide on the acceptability of the proposal.

7.We have therefore set in hand some contingency planning. We plan to:

• Commission consulting actuaries to quantify the probable liability for mis-selling, by comparing the value of Equitable’s policies with the average value of comparable products from other providers (this is the test which we anticipate Counsel will propose to quantify the loss to policyholders of mis-selling);
• Commission an independent review of its financial position.

8.In the worst case scenario, we may need to consider liquidation of the Society. This could take a number of forms but each of them would involve the Policyholders Protection Board becoming involved, either to seek a transfer of the business to new ownership (highly unlikely, given the history), or to pay out to policyholders 90% of their benefits. Putting the company into administration, which would be a preferable alternative, is currently not permitted by law. We understand that the relevant provisions of [FSMA 2000] which enable appropriate regulations to be made which would allow this have been commenced, but the regulations themselves (which will be complex) have not yet been drafted.

9.A further factor in all this is the outcome of the Review of the FSA’s supervision of the Equitable since 1 January 1999. The report is almost complete, but some maxwellisation of former members of the Equitable is still required. Our best estimate is that the report will be ready for publication by the Treasury in September or October.

FSA’s Head of Actuarial Support writes to Chief Counsel B about Counsel’s opinion (received on 20/07/2001 [15:51]). The Head of Actuarial Support writes:

This draft appears to say that all policies sold since 1988 (and any pre-88 policies on which premiums have increased by 10% since 1995?) may have been mis-sold, and that the quantum of any loss may have to be determined by comparison with a similar policy sold by a “median” insurer.

However, there is some suggestion, which seems quite surprising really given that policyholders would only recently have been aware of this omission by Equitable (perhaps in 1998), that the Limitations Act could rule out claims for policies sold more than 6 years ago (or perhaps only in respect of premiums paid more than 6 years ago).

Nevertheless, even if claims could only be submitted for premiums paid on non-GAR policies since mid-1995, the potential liability could still be around £2-3 billion.

Do we know if [Counsel for Equitable] is likely to reach a similar view?

An official from FSA’s Press Office informs the Head of Life Insurance that Equitable’s website says: ‘The FSA is responsible for safeguarding the interests of policyholders’. The official says: ‘I’m not at all sure that’s right. Are they over-promising what a regulator can deliver as much as they over-promised their fund?’.

The following day [at 09:15], the Head of Life Insurance says that he did not have any problems with the wording as ‘it is what we aim to do’.

On 25 July 2001 [16:21], the Director of GCD agrees with the Head of Life Insurance’s comments.

[16:37] The official explains that her concern was that ‘it implies a guarantee that we can always safeguard their interests – which many consumers would no doubt take to mean that we are safeguarding the value of their investments …’.

FSA’s Director of GCD circulates copies of the two Counsel’s opinions on mis-selling. The Director later circulates a note summarising the opinions.

[17:54] The Head of Actuarial Support says that the financial implications look quite bleak:

If, for example, they are likely to incur mis-selling claims on all post-1993 policies, then the liability could be around £3–4 billion, which would be well beyond their current free reserves on a Companies Act basis of around £1½ billion. If the potential claims extend back to 1988 or even earlier, then the situation is clearly even worse.

Even if the Limitations Act applies (which seems very odd to me as a layman given that it was not the fault of the policyholders that they could only have been likely to have become aware of the alleged non-disclosure in 1998 or even later), then the liability could be around £2½ to £3½ billion, assuming that there would be a liability in respect of all premiums paid in the last 6 years. The result is still then likely to be insolvency.

Managing Director B, the Director of Insurance and the Director of GCD meet to discuss the position and to agree the immediate action to be taken.

[20:23] Following the meeting, the Director of Insurance comments:

It seems to me that the analysis in the two opinions raises the possibility that other companies which wrote GAR business might face similar claims. This might arise where Companies are paying GAR liabilities but their ability to do so (as falls in equity markets reduce their free assets) comes to be at the expense of asset shares for policyholders generally. In such cases it seems possible, at least in theory, that the “[Counsel for FSA] test” of the quantum to be attached to any misselling claims, as the difference in value between affected policies and policies issued by companies which did not sell GAR policies, could potentially produce substantial additional liabilities.

The work I have asked [the Head of Actuarial Support] to do, in fairly rough form, is to look at the companies which we know have written significant volumes of GAR business, and to provide such assessment as he can, by reference to what we know of their free asset position, of the point at which they would be likely to deliver (or may already be delivering) less than asset shares to policyholders because of the need to meet GAR liabilities.

When we have this assessment, I think we will need to take a view on:

a) whether such misselling claims, if they are likely to arise, could imperil further companies.

b) whether it is possible to make any assessment of the possible impact on the industry generally through the compensation schemes and of the ability of the industry to absorb this impact.

Depending on the results of this work we may need to consider briefing the Bank/HMT/FSA standing committee. I am mindful that we have said publicly that we briefed the committee in December on the Equitable situation, and that at that time the Committee’s view was that there was no threat to financial stability. While this may still be, and probably is, the correct view it might do no harm to reconsider the position.

FSA’s Chairman asks for a meeting on 26 July 2001 to discuss ‘the interplay between solvency and the GAR scheme and raise the issue (even if only to dismiss it) of whether policy-holders would be best served by activating the compensation scheme now’. The Chairman says that he also thinks that FSA needed to think through their rationale for:

l Why we did not do anything about the misselling liability at the time?

l What, if anything, should we do about it now?

FSA’s Insolvency Practitioner circulates two draft letters, the first to Equitable requiring them to instruct investigating accountants and the second to the investigating accountants. He comments that he thinks Counsel’s advice to FSA becomes discoverable if they shared it with the investigating accountants ‘unless [the Director of GCD] can find a way around this’.

The following morning, Managing Director B circulates an amended version of one of the letters.

Further to Chief Counsel B’s query of 17/07/2001 [10:00 and 15:12], the Director of GCD replies again (see 18/07/2001 [09:52]), confirming his understanding of the advice to be that ‘compensation could be paid on an amount set by the court to represent undeclared terminal bonus’. The Director of GCD continues:

I think there’s a difference between this and paying compensation on what a company itself estimates as intended future bonus. But is the conclusion that policyholders would have been better putting the company into liquidation before? Or would the same exercise take place whenever the company went into liquidation? And if so, isn’t that the answer to our article 4 concerns? And surely this could mean that liquidation could be better than a 425 scheme, depending on the impact of that scheme on PRE? We also need to consider whether we should be advising policyholders to stay in rather than go, because PRE will be compensatable – subject only to a 10% penalty – on liquidation.

FSA meet Equitable to review the position of the Society. FSA’s note of the meeting records discussion on the following issues:

Independent review of Equitable’s financial position and likely mis-selling costs

FSA explain why they thought the reviews were necessary and hand over draft instructions for investigating accountants and investigating actuaries. Equitable’s Chief Executive accepts the reasoning behind the review of the financial position but ‘was less sure’ about the review of mis-selling costs. The note records: ‘In this context, the impact of Article 4 of Equitable’s Articles became important. We reminded him that both FSA and the Society had legal opinions which suggested that Article 4 would not protect the Society from insolvency’. It is agreed that both sides would revisit the issue.

Subordinated loan

Equitable’s Chief Executive reports that the annual payment on the subordinated loan, of about £28m, becomes due on 6 August 2001. The Chief Executive notes that, if the required minimum margin were not met, then the payment could be passed, but this could lead to policyholder panic and a run on the fund. He confirms that bondholders could not petition for winding up. However, FSA comment that they thought any six policyholders could petition for winding up on just and equitable grounds. FSA agree to research the position further.

Top-ups to GAR policies

Equitable hand over Counsel’s further opinion, which advised that four weeks’ notice should be given of any cancellation of top-up rights. FSA and Equitable agree to consider how much notice would be required.

Press criticism

FSA ask for Equitable’s Chief Executive’s reaction to press criticism that policy values had exceeded fund value for an excessive period. The note records:

[The Chief Executive] said that his view was that at the end of 1999, policy values were too high and could have been corrected by a 1% reduction of bonus rates in at least some years during the 1990s. The divergence had become significant over the last eighteen months, with the emergence of the GAR problems. For a normal fund, even this divergence need not have been a problem; but the Equitable had an unusually high proportion of policyholders approaching maturity, so that the over payments were particularly costly. Nevertheless, the company’s policy had been reasonable; it was [defensible] to regard the divergence as consistent with normal smoothing as [late as] spring 2001, when the new board undertook its financial review.

On 27 July 2001, Equitable send FSA a copy of their notes of the meeting. FSA provide their comments on the notes on 3 August 2001. According to Equitable’s notes of the meeting, on the proposed reviews:

[Equitable’s Chief Executive] commented that solvency in general tends not to be a concern, however, meeting [the required minimum margin of solvency] is an issue particularly given the well-known fundamental uncertainties faced by the Society. He was happy for investigations to be undertaken. The range of numbers regarding the quantum of mis-selling claims is potentially very large, including values higher than the cost of the House of Lords’ ruling which would threaten the solvency.

FSA change the final word ‘solvency’ to ‘RMM’, (i.e. required minimum margin).

Equitable’s solicitors telephone FSA to ask whether they planned to publish their Counsel’s opinion and, if so, to request sight of it. FSA say that, if they were to publish anything at all, then it would be after Equitable had published their own opinion and that FSA would give Equitable notice.

[16:23] Line Manager E says that it would be unusual for FSA to publish their opinion but says that FSA might want to draw upon it in any report on mis-selling.

[21:26] The Director of Insurance agrees and informs them that FSA’s Chairman’s view was that FSA should express their view on mis-selling at the same time as Equitable.

The following morning (at 08:29), the Director of GCD also informs them that FSA’s Chairman had made it clear to Equitable’s Chairman that FSA would not want a gap between publications.

FSA’s Director of GCD sends the Insolvency Practitioner the comments of Counsel on draft letters to Equitable requiring them to commission independent reports into their financial position and estimate of mis-selling liabilities.

[17:41] The Head of Actuarial Support queries two points.

FSA’s Insolvency Practitioner sends the Director of Insurance the final version of the letter to Equitable requiring them, pursuant to sections 44(2)(B) and 45(1) of ICA 1982, to commission a report from their Appointed Actuary’s company providing an analysis of Equitable’s financial position as at 30 June 2001.

The Insolvency Practitioner also sends a further draft of a letter to a different firm of actuarial consultants, commissioning an estimate of the extent of mis-selling liabilities.

FSA’s Director of GCD writes to his Chairman, in response to a request for advice on how FSA might respond to queries about their role in relation to mis-selling. The Director of GCD provides the following draft questions and answers, highlighting that the material would need to be checked before finalisation:

Q You tell us now that your rules mean that the Equitable has been required, since at least 1993, to disclose to potential policyholders the existence of the GARs. What disclosure should the company have made?

A

• The advice we have had is that the company should have disclosed the fact that it had GAR liabilities which a reasonable policyholder could think might affect the amount available for distribution by way of bonus.
• These liabilities would not have been disclosable if the company had put in place arrangements to mitigate them, for example by reinsuring them, or taking out an interest rate swap.
• Nor would they have been disclosable while the company had robust and unchallenged legal advice that its differential bonus policy was valid.
• But in fact it never had such advice. From 1988 to 1998, it was operating without the benefit of legal advice. The advice it received in 1998 was only given in the context of the challenge made, which the company concluded needed to be taken to court in order to provide clarification of the position.

Q Why was no action taken about it at the time?

A Determining whether to make this disclosure was, in the first instance, a judgement for the company to make, with its own knowledge of its commitments, and the assets available to meet them.

• This issue first came to the attention of the FSA at the beginning of 1999. [Is this true?] By that stage, the company had had legal advice that its bonus policy was valid, but had also decided that the issue needed to be tested through the courts.
• In the circumstances, no action was taken to insist on a disclosure, given that the true position remained a matter of dispute before the courts. That is not to say that we now take the view that no appropriate disclosure could have been made.

Q What action will you now take on the basis of this conclusion?

A We will:

• ensure that proper redress is provided from the assets of Equitable Life either by requiring Equitable Life to pay redress to these policyholders, or by satisfying ourselves that proper provision is made for credit to be given through the proposed compromise between the different class of policyholders;
• consider whether any action is required personally against those at Equitable Life responsible for its action;
• consider whether there are other companies in a similar position, where similar action is required.

But we do not intend to take action to fine the Equitable Life itself. This would only  penalise the policyholders, by reducing the assets available to them.

Q Can policyholders sue you for failing to ensure that proper disclosure was made?

A We believe that we have acted reasonably throughout. The proper source of redress for misselling is the company which missold the investments concerned.

FSA’s Director of GCD provides advice to the Director of Insurance on Counsel’s opinion on top-up rights and on ‘whether it would be possible for FSA to express the view to the society that we would not take action against it on PRE grounds if it were to give 6 weeks notice, instead of 4 months’. The Director of GCD advises that this would depend on whether, in all the relevant circumstances, six weeks would be sufficient to enable policyholders to determine whether or not to make a top up.

A PIA legal file on Equitable includes a ‘Note for Record’ of a meeting of FSA (Managing Director B, Director of Insurance, Chief Counsel B, Legal Adviser D, Head of Actuarial Support, Head of Life Insurance, Insolvency Practitioner, Line Manager E and another official) and Counsel to discuss the draft opinions of both Counsels. (Note: a copy of this note does not appear to be held on any of FSA’s files.)

The two-page note records:

Key Points

1.[Counsel] agreed that the FSA could send [Equitable] a copy of his draft opinion with the caveat that it was likely to change significantly before being finalised and also that it was provided in confidence and therefore should not be published. Final version of opinion expected to be delivered [by close of business on] 30/7.

2.[Counsel’s] draft opinion implied that [Equitable] was insolvent (and had been for some years). This conclusion was based on three points (require clarification!)

• If full disclosure had been required non-GAR policies would have been unsaleable.
• ? s459 of Act – limitation period?
• Non-GAR contracts prevent [Equitable] using profits to discharge GAR liabilities.

3.If, as expected, [Equitable] publish [Counsel’s] opinion, others would be free to draw the same conclusions.

4.[Counsel] noted that [the Counsel for Equitable] opinion requires an initial judgement that the policy documentation effectively promised non-GAR policy holders “fair” share of the profits. It is, however, very improbable that [Equitable] believed that they were operating under such an arrangement. [Counsel] thought it arguable that, on the basis of the documentation, non-GAR policy-holders were unlikely to expect a smoothed share of profits. Indeed, the policy documentation makes no reference to asset sharing.

5.[Counsel] noted that the 1994 Lautro rules required disclosure of any risk which may have had an adverse effect on performance or was otherwise material to an investors decision to invest. Attendees discussed whether it was reasonable to assume that the GAR risk should have been disclosed to non-GAR policyholders.

6.It was agreed that if the GAR risk had been recognised by [Equitable] management it potentially should have been disclosed to policyholders. However, given the economic environment during the late 80s/early 90s, the probability of the GAR risk materialising was minimal. In addition, because [Equitable] did not take legal advice on whether they were mis-selling the non-GAR policies at the time, they were unable to form a view of the probability and impact of the risk materialising. Ultimately [Equitable’s] management had failed to consider the implications of what was then a highly improbable potential risk, but they should have recognised the potential legal uncertainty and sought a legal opinion.

7.[Managing Director B] noted that the policies included options which were at the time so far out of the money that [Equitable] may not have … considered [them to be] a disclosable risk. However, the inclusion of the options could reasonably have been expected to be disclosed in the product literature.

8.Attendees then discussed at what point [Equitable’s] management could have reasonably anticipated the full impact of the risk materialising. [Paragraph] 3 of the [Counsel for FSA’s] opinion noted that it was unclear when the full implications of the risks were appreciated.

9.It was noted that the regulatory implication of the [Counsel for Equitable’s] opinion was that mis-selling liabilities across the insurance industry could amount to a systemic level.

10.[The Director of Insurance] asked [Counsel] to consider the arguments about likely quantum (noting that as late as 1999, [Equitable’s] auditors considered the quantum of the potential risk to be much smaller than current estimates) and materiality factors in his final opinion.

11.[The Director of Insurance] asked whether Article 4 of [Equitable’s] constitution could be interpreted as enabling liabilities to be reduced proportionately to assets available to meet them, thereby reducing both GAR and mis-selling claims. If so it would, in effect, transform these liabilities from cumulative liabilities to offsetting liabilities which could be reduced/compromised without threatening solvency. [Counsel] confirmed that he thought this interpretation was unlikely:

• his interpretation of the principle aim of the provision was to ensure that members could not sue other individual members of the society;
• Article 4 refers only to policy claims and is therefore not applicable to mis-selling claims.

[Counsel] concluded that Article 4 offered no comfort to [Equitable’s] Directors in relation to wrongful trading (whilst insolvent).

12.All parties agreed that a s425 scheme achieved through administration, rather than liquidation, was the most sensible way forward. This would enable [Equitable] to continue operating but provide Directors with the protection of the courts. The alternative of liquidation would be very disruptive. Another option was for the Board to seek financial assistance from the industry. It was agreed that the FSA should raise this issue with the [Investors Compensation Scheme].

13.[Line Manager E] noted that [Equitable] had received advice that mis-selling claims should be included in the 425 scheme. However, there were obvious doubts over the extent to which claims could be accurately estimated within the tight timescale dictated by the Halifax deal. A pragmatic solution would need to be agreed.

FSA meet with HMT and the Bank of England to discuss Equitable before attending an emergency meeting of the Tripartite Standing Committee (Deputies). HMT’s note records the discussion that took place under the following headings:

Latest situation

FSA’s Chairman reports that Equitable’s Board had met earlier that day and had decided that it was possible for the company to carry on for a short period ‘although it was not clear how long that would be’. It was assumed that the Board had concluded that they were still solvent in Companies Act terms.

It is noted that Equitable had to make an interest payment on the subordinated loan of £30m, due on 3 August 2001 (rather than on 6 August 2001, as had been previously thought). Equitable thought they could meet the payment, if FSA granted a waiver in respect of regulatory capital requirements. It is noted that FSA were yet to decide whether they would grant this.

FSA’s Chairman explains that he had had discussions with the industry, without the knowledge of Equitable or HMT, about possible support for the company. He says that the industry would require a lot of persuasion to make any contribution and, even if they would be willing to do so, ‘would say that this could not be organised in the time available before Equitable had to go into provisional liquidation’. FSA note that they consider that the best way forward was to make administration available for insurance companies.

Statutory compensation schemes

The operation of the Policyholder Protection Act 1975 and the Investor Compensation Scheme are explained by FSA.

Liquidation vs. S.425 scheme

The different features of provisional and full liquidation and schemes under section 425 of the Companies Act 1985 are considered.

Administration

The possibility of introducing an administration procedure for insurance companies is discussed but: ‘It was uncertain if everything could be done before the end of next week’. FSA’s chairman acknowledges the constraints of getting this in place but says FSA would want HMT to see if a scheme could be brought in within the time available. It is noted that administration ‘represented the best current card in a weak hand’.

In concluding the discussion: ‘[An HMT Director] noted that perceptional factors together with the likely availability of the Halifax funding favoured administration over provisional liquidation. However, the feasibility and safety of getting the necessary legislation to provide for administration for insurance companies through in the required timescale needed further consideration’. It is agreed that ‘experts’ should meet on 26 July 2001 to discuss this further.

All of the same officials from FSA, HMT and the Bank of England then attend an emergency meeting of the Tripartite Standing Committee (Deputies) ‘to consider whether Equitable Life’s difficulties represented any systemic risk and, if so, what the response might be’. HMT’s note records the discussion that took place inter alia under the following headings.

Misselling

The Bank of England say that Counsel’s opinion seems very important. The note records:

[FSA’s Director of GCD] said that [Counsel] had been appointed by [Equitable] to investigate the extent of their policyholders claims against them, and to produce an opinion for publication. An initial opinion had been produced in May and a final opinion was expected to be published at the end of July. The opinion looked at [Equitable] contracts both against background of the ordinary laws on mis-statement and the LAUTRO and PIA rules. These rules required disclosure of any information that would affect the amount available for distribution to policy holders. There were three relevant factors: the size of the GAR liabilities; the size of the company’s overall assets; and the existence or not of hedging contracts. In [Equitable’s] case there were low assets, high liabilities and lack of hedging.

Case for Intervention by the Authorities

The issue of whether there were arguments for an injection of public funds into Equitable is discussed. The note records:

[FSA’s Chairman] said that something between £3[bn] and £5bn would make [Equitable] solvent. [FSA’s Director of Insurance] said that it was difficult to assess what additional contribution to the pot might be necessary to make a s.425 scheme attractive to [Equitable] policyholders. But while the insurance industry would probably not be keen on a rescue, it might be readier to consider this if the government was involved. [FSA’s Chairman] said that if the government put money into the company, it would be interpreted as a problem with the past regulatory regime.

Moral Hazard

Moral hazard issues are also discussed:

[FSA’s Chairman] said that it was possible to contemplate basing support on a change in the environment. This kind of intervention would fall somewhere in between ameliorating systemic risk and admitting that the regulatory system had not worked perfectly. He thought this circumstance could be distinguished from regulatory negligence.

Next Steps

It is noted that FSA were to review the situation with Equitable on 27 July 2001 and that there was an Equitable Board meeting planned for 30 July 2001 (Note: this was later brought forward to 29/07/2001). Discussion goes on to note:

The [Equitable] were due to make a payment on 3 August that would focus their attention on Insurance Act solvency requirements. They could only make the payment if their required margin was intact or if they received consent from the regulator. It would be difficult for the FSA to consent to this if there were no clear way forward for the company but permission could be given if FSA were satisfied the company did have a good plan in place. It was noted that, if [Equitable] failed to make the interest payment, it would be recognised that it could not meet its commitments and liquidation of the company would be precipitated.

[An HMT Director] asked whether the company should be allowed to continue in business until Friday on the basis of what was known now. [FSA’s Director of Insurance] said … that there were high hurdles for FSA intervention. It was also the case that the misselling liabilities had not been quantified and might possibly be small. [FSA’s Director of GCD] said the legal position was that the FSA could intervene if they thought [Equitable] was insolvent or if they thought that they could not meet the reasonable expectations of their policy holders. They believed the right course at this stage was to get more information.

[FSA’s Chairman] said that the FSA did not have grounds to overturn the Board’s view that [Equitable] was still solvent in Companies Act terms. But the FSA would only consider granting [Equitable] the waiver for regulatory capital purposes that would be necessary to pay the interest on their debt if they could see a plan for putting the policy holders in a better position than they would be if [Equitable] was liquidated immediately. The FSA would need to able to see that by next Friday when the payment was due to be made. The Treasury would have to make a judgement about the probability of an administration scheme’s being in place in time. If the Treasury felt that the necessary steps could be taken to allow the [Equitable] to go into administration, the FSA would feel comfortable about advising Ministers that they should be allowed to make the payment. If administration was not likely, then it would be better to move to liquidation quickly rather than waiting until after the interest payment had been made.

In summing up: ‘[HMT] said that the FSA should put advice to Ministers on the issue of what should be done in respect of the interest payment if [Equitable] fell below its regulatory capital requirements. Treasury officials would advise on the administration scheme issue … [HMT] would brief the Chancellor’.

On 30 July 2001, the Director of Insurance sends HMT’s notes of the meetings to Line Manager E, copied to the Head of Life Insurance and the Insolvency Practitioner. He says to them: ‘I think we should keep only one file copy of this. I should be grateful if [the Insolvency Practitioner] could destroy his copy when read’.

FSA’s Insolvency Practitioner writes to the Director of Insurance following the meeting of the Tripartite Standing Committee. He says that he had three points to add to what had been discussed. First, that it was important to involve the people who might be asked to act in the event of liquidation/administration. Secondly, he sets out the timing and funding of potential mis-selling compensation from a liquidator and the Investor Compensation Scheme. Thirdly, reiterating a point he had made outside the meeting, he says that he believed ‘the best way for the directors to be comforted that they may continue trading and paying claims in full whilst the GAR and misselling liabilities are uncertain, might be if they receive a written undertaking from the [Investor’s Compensation Scheme] that the [Investor’s Compensation Scheme] will contribute to a s.425 scheme up to the amount that it would have to pay by way of compensation in a liquidation’.

He continues:

This does not necessarily mean that creditors will be no worse [off] if the scheme fails and liquidation ensues; and therefore the directors remain exposed for wrongful trading liabilities to the extent that the society pays terminal bonuses and subordinated debt interest meanwhile. However, the test the directors face is whether there was no reasonable prospect that the society would avoid going into insolvent liquidation [under section 214 of the Insolvency Act 1986]. If the scheme could be sweetened by up to £5bn (say) then there remains a realistic prospect of such a scheme succeeding.

• this does not mean that a view need be taken now on whether £5bn is indeed the amount of the misselling liabilities.
• The [Investor’s Compensation Scheme], I presume, has power to provide “financial assistance” along the lines of the [Policyholders Protection Board], but extended to situations where there is merely a prospect of the society being unable to pay its debts. [Chief Counsel B] should advise.
• If so, this commitment can be made immediately (if [the Investor Compensation Scheme] board concur) without the need to obtain agreement from the [Association of British Insurers] or industry generally.

The directors will still need to be robust and have robust advice, but I believe that such an arrangement will strengthen their position significantly.

I think the FSA could apply the same criteria when considering whether to intervene in policyholders’ interests.

The Insolvency Practitioner also prepares an ‘Illustration of the possible cost to the industry of funding compensation through the Policyholders Protection Board and the Investors Compensation Scheme’. The illustration is presented as follows:

The notes to the illustration are:

It is assumed that the Society would go into liquidation and a stop order made since a transfer of the business to another insurer could not be achieved. Only on such a liquidation would policyholders have any prospect of the [Policyholder Protection Board] paying compensation in respect of undeclared terminal bonuses.

The obligations of the Halifax to the Society in respect of unit linked business and of the Society to unit linked policyholders have been ignored on the assumption that Halifax would pay such policyholders directly and assume their rights against the Society.

a It is assumed that the market value of the Society’s investments have fallen in proportion to the FTSE 100 between 5,700 at 30 June and as at 24 July 5,320 with an asset backing 45%.

b Liquidation costs are estimated to comprise:

c On liquidation a policyholder can prove for the full value of his GAR rights irrespective of whether he would actually have exercised them: £2,400m.

d The [Investor’s Compensation Scheme] limits compensation to £48,000 for each claimant.

• Assume that the total misselling claims are tortious and total £5,000m.
• Assume that there are 300,000 non-GAR policyholders who were sold policies after 1988 and who are eligible for compensation.
• Assume that the damages each policyholder is entitled to claim falls in a normal distribution about the average of £16,667 per policyholder with a standard deviation of £10,000.
• Then only 0.086% of policyholders will have their claims capped.
• Thus, compensation payable by the [Investor’s Compensation Scheme] will be approximately £4,987m.

FSA’s Chief Counsel B circulates a draft report entitled ‘PIA misselling report’. The Chief Counsel explains:

The report adopts and explains the reasons behind the conclusions reached by counsel about the nature and the extent of misselling by the Equitable; it also deals with an issue not currently in the draft [counsel] opinion, namely, the sale of new policies after the Court of Appeal judgement and following the House of Lords ruling. My conclusion is that the disclosures given by the Equitable during both of these periods were inadequate but I hope that I have dealt with [the] closure to new business point in a way which colleagues will find comfortable.

The report states:

The basic proposition underlying the regulatory requirements which apply to the Equitable throughout the period is that potential policyholders were entitled to:

• be told the nature of investments they are being sold;
• have proper care taken in the information and advice given to them;
• be given information about any special features of the liabilities of the Society which a reasonable policyholder would expect might affect that amount available (then or in the future) for distribution by way of bonus.

and goes on to find that:

… no policyholder could have been reasonably satisfied that the GAR risk was immaterial and therefore something which did not need to be disclosed as part of a process by which potential policyholders were able to take informed decisions. On this basis the regulators agree with the conclusion reached by counsel … that the Equitable failed, in a generic way, to comply with the disclosure requirements to which it was subject both under the initial Lautro rules and the later PIA Key Features rules. This was a failure which commenced when, on an objective basis, an investor would have reasonably concluded that the Equitable’s exposure to GARs was a material risk. Given the Equitable’s own assessment that, on a proper assessment of the GAR contracts, non-GAR policies supported in the same with profits fund were un-saleable, the risk to policyholders was material from the out set – [July 1988] – and hence the Equitable breached the disclosure rules from that date.

This conclusion is one which, on the basis of the material considered by the regulators and by counsel, affects the sale of all Equitable policies up to the publication of the House of Lords decision on 20 July 2000.

The report discusses the sales of policies during the Hyman litigation finding that correspondence from Equitable to policyholders during that period had not properly reflected the range of possible outcomes. However, it concludes: ‘The Equitable’s failure to properly disclose the range of outcomes presented by the litigation is however of secondary significance given the more fundamental failure identified in relation to the sale of Equitable policies from July 1988’.

On the sale of policies after the House of Lords’ decision, the report states:

The material on which sales representatives were encouraged to answer questions lacked balance and in the regulators view does not conform with the duty to provide investors with adequate information. This therefore gives rise to a further category of potential missales.

FSA meet the Association of British Insurers to discuss a possible industry response to the Equitable situation. FSA’s ‘Note for File’ records that:

The position of the Society was very delicate. A leak could prove extremely damaging. The company’s financial position was finely balanced. [FSA’s Chairman] explained the legal opinions which the Society and the FSA expected to receive shortly in respect of possible mis-selling. It was clear that these opinions had potential consequences for a number of companies but these could be very variable. The test which Counsel were likely to suggest for quantifying possible losses arising from mis-selling was essentially that where a policyholder, properly informed of relevant and material risks would not have bought a policy from the company but would have bought one from another provider, then the measure of damage was the difference between the value of the policy actually bought and the industry average for comparable products supplied by other providers. In the case of the Equitable the consequences looked severe, although no systematic quantification had yet been done.

FSA inform the Association that ‘while the [Society’s] directors had concluded that they could properly continue the operation for the time being the situation might change very quickly’.

The possibility of industry support for the compromise scheme is discussed. FSA record that their Chairman had explained:

In our view such a compromise still offered the best prospects of a reasonable outcome for policyholders and was still achievable if the Society was in administration or provisional liquidation. However, it now seemed likely that for it to be attractive to policyholders it would need to be “sweetened” with some additional finance.

FSA’s note continues:

[FSA’s Chairman] explained that on the basis of some initial and somewhat tentative calculations, it seemed to the FSA that the amount needed to make such a compromise attractive to policyholders (and thus likely to succeed) would be considerably smaller than the cost that the industry would be likely to incur if the company went into full liquidation with compensation being payable to policyholders both through the Policyholders Protection Board (in respect of policy liabilities) and through the investors compensation scheme (in relation to mis-selling claims). He suggested that further discussions might take place, without commitment on the part of the industry, between technical experts to explore both the relative costs and the processes that would be involved.

The response of the Association to FSA’s suggestion is recorded by FSA, as follows:

The [Association of British Insurers’] representatives expressed considerable doubts about the proposition. It was not clear why policyholders who had chosen to invest in well managed companies should be expected to bail out those who had invested in a company which was less prudently managed. They were concerned too that the legal opinion seemed unbalanced and potentially hugely damaging. They were concerned that the reasoning might extend not only to guaranteed annuity rates but to all forms of guarantee and potentially to all risks inherent in with-profits policies. Publication of these opinions could lead to a clamour for a major review of mis-selling beyond even the size and scale of the pensions review.

FSA also record that the Association of British Insurers were:

… concerned in particular about the quantification test likely to be suggested by Counsel. This raised the spectre that any policyholder in a fund performing below the industry average would be given an incentive to complain that he had been exposed to some undisclosed risk and to insist that his policy value was brought up to the industry average.

FSA’s Chairman expressed the hope that the Association would not take an immediate decision not to explore the possibilities. The Association of British Insurers’ representatives ‘reluctantly agreed that some initial work should be done’.

FSA’s Director of GCD reports to Managing Director B on his discussion with Counsel for FSA about the appropriateness of the measure of mis-selling liabilities identified in the two Counsels’ opinions. This discussion had followed comments made by FSA’s Chairman the previous day. FSA suggest to their Counsel that it might be possible to conclude that the usual tortious measure of damages was not appropriate in this case. The Director of GCD explains:

This is on the basis that it would produce an over recovery, by compensating people not only for what they have lost as a result of the effect of the GARs on bonus distributions, but also because of the fact that, coincidentally, particular Equitable policies may have under performed the market.

[12:53] Managing Director B thinks that this is a logical approach and ‘avoids the concerns discussed at this mornings meeting with the [Association of British Insurers] about averaging-up and the potentially very damaging consequences for the industry as a whole’.

[13:12] The Head of Actuarial Support adds that this would tie in better with Counsel for Equitable’s opinion, which had said that the mis-selling liabilities would have to be met from the fund prior to establishing the surplus available for distribution as bonus. The Head of Actuarial Support continues: ‘It could therefore achieve the outcome that they were seeking, namely to restore the balance between GAR and non-GAR to roughly where it was prior to the [House of Lords’] judgment’.

On the commissioning of an independent assessment of Equitable’s potential mis-selling liabilities, the Head of Actuarial Support goes on to say:

Meanwhile, [a firm of actuarial consultants] have declined to take on the assignment that we offered them as they did not wish to be associated with the view that mis-selling had taken place (when this could have implications for other insurers) and would therefore be not in their commercial interests (on which we may have our own private views!). I can try to talk with [another actuarial consultancy] (or failing them some other smaller firms) to see whether they would take on this assignment, but if [the Director of GCD] is right, this may not be quite so pressing now.

[14:10] The Head of Life Insurance says that he thought FSA still need an independent assessment of quantum ‘so as we agreed, please contact [the actuarial consultancy] to explore the position’.

[15:03] The Director of GCD provides some further comments following an update from Counsel.

Equitable provide FSA with information on the distribution of assets of the with-profits fund as at end-June 2001. Equitable explain that, since then, they had sold around £1.4bn of equities, of which £1bn were ‘overseas’.

FSA’s Head of Life Insurance forwards the information to Managing Director A saying ‘I hope this is enough to meet [the Bank of England’s] needs at present’.

FSA’s Chairman meets with the Economic Secretary to the Treasury to provide an update on events.

An FSA official relays a report from FSA’s Chairman giving feedback from a meeting with the Economic Secretary to the Treasury. The feedback includes that:

• An HMT Director was convinced that making administration available was the best option but the Economic Secretary ‘has not quite got there’ and was concerned that some policyholders might be disadvantaged by this.
• HMT ‘recognise that it is quite possible that the Board will decide on Monday that it cannot make the interest payment and will choose to put the Society into provisional liquidation or, if available, administration’.

[19:33] The Insolvency Practitioner replies with three observations on the subordinated loan, including: ‘For a test of wrongful trading or a Companies Act solvency test it is irrelevant that the debt is subordinated to policyholders’ claims (if that is the effect of subordination). A company must be able to foresee its ability to pay all its liabilities of whatever nature’.

Equitable provide FSA with an update on their attitude to the interest payment on the subordinated loan. FSA record:

1.On the basis of the 2000 regulatory returns, submitted at the end of June 2001, and reflecting the valuation as at end 2000 (the “traditional” basis for assessing a life office’s financial position for the purposes of such matters) the payment could properly be made, as the [required minimum margin] would remain intact after the interest payment. But [the Chief Executive] implicitly recognised that in the Equitable’s current circumstances, this test lacked some credibility.

2.Therefore the directors were giving thought to whether it would be appropriate for them to make the interest payment if the company was insolvent in Companies Act terms. They might decide to do so, on the basis that a £28m payment was justifiable if it could sustain the Society through the period until an orderly administration could be arranged. But [Equitable’s Chief Executive] recognised that this would be a brave decision.

3.They were clearer now (but still not crystal clear) that 1st August was the date by which irrevocable instructions had to be issued to make the payment due on 6 August. [The Chief Executive] thought that it might be helpful if by that date, FSA had not received firm advice on the likely quantum of misselling liability.

We are considering what attitude to recommend the Treasury should take on possible consent to this payment even if the [required minimum margin] is breached. The issue will be on the agenda for tomorrow’s meeting with Equitable.

FSA’s Head of Life Insurance relays this information to supervisors and also tells them that this issue might be overtaken by reports that a stockbroker had suspended a credit facility for Equitable on the grounds that they were insolvent.

The following morning [at 09:46], the Director of GCD comments that, in relation to paragraph 3 above, ‘there can be no question of it being “helpful” for us not to have received advice on quantification by the key date’.

FSA meet Halifax following a rumour that had been circulated on the wire press that a stockbroker had stopped a foreign exchange line of credit to Clerical Medical on the grounds that Equitable was insolvent.

FSA contact the stockbroker to establish whether there was any truth in the rumour. The stockbroker says that the credit facility was due to end on 27 July 2001 and their credit committee had decided that they would require collateral of $5m as assurance in order for them to be able to renew the line of credit. Equitable had refused the terms and the line of credit had not been renewed.

FSA’s Managing Director A sends FSA’s Chairman, Managing Director B and the Director of Insurance his note of the meeting with Halifax’s Chief Executive and also a note of a one-to-one conversation with him. The Managing Director says:

We discussed this briefly with [the Chief Executive] who has undoubtedly (as a result) gone away to think hard about how Halifax would respond to a problem with Equitable if one did emerge …

At [the Chief Executive’s] request I also talked to him one-to-one. [He] stressed how much Halifax had riding on the Equitable and I decided to tell him something of what was in hand, given that they may have some useful influence with Equitable and, importantly from a supervisory perspective, it is important that they are not destabilised by for example not being able to explain properly what Halifax exposures are if a problem did emerge.

I explained that the water had been made deeper and muddier by [Counsel’s] Opinion (the creation of which he is, of course, only too aware of) and by the difficulty of knowing what it might mean to Equitable’s solvency. I said that further information was being gathered (but this would take time) and in the meantime we were vulnerable to a loss of confidence by the Equitable Board who might decide they could not go on. I said we were exploring every route to find a breathing space of the kind administration brings if the circumstances justified it.

FSA’s Line Manager E prepares a note on Equitable’s subordinated loan. He explains that the only view he could reach is that Equitable should go ahead with the interest payment on the loan if the solvency cover was intact but not if their cover for the required minimum margin had been breached. The Line Manager says that: ‘In the time scale, I cannot see that there would be an [required minimum margin] breach that would not be tied in with other things that would make allowing the payment to be made preferable to not consenting’. The ‘Detail’ section of Line Manager E’s note states:

We need to decide whether or not supervisory consent should be given to the Society and [Equitable Life Finance] to proceed with the next interest payment on 6 August 2001 in the event that the position on the potential mis-selling issue is clearer and the Society declares that it is no longer able to cover its [required minimum margin].

In simple terms, the downside of not giving consent is that the terms of the bond backing the loan are public and indeed, as the debenture is [London Stock Exchange] listed, it seems likely that a formal statement would need to be made acknowledging the Society’s [potential] financial difficulties. That would have serious consequences for confidence among policyholders, and could also be damaging to markets that would expect the Society to be forced to begin making urgent disposals of its equity holdings (approx £8 billion including indirect holdings). This would be anticipated either as part of a switching strategy to move to gilts and other fixed interest, or as part of a formal insolvency procedure.

On the other hand, the loan arrangements were consented to and have been acceptable for solvency purposes on the basis that the loan debt was subordinated to the other liabilities of the Society, and in particular the insurance liabilities. If at a time when the Society is unable, or likely to be unable, to meet its obligations to its policyholders in full, it seems somewhat implausible that the regulator should wish to undermine the protections that have been put in place for relevant policyholders. It is though important to recognise that the interest due (at £28 million) is fairly small scale compared with the overall reserves (£25 billion for the with-profits liability).

It would seem, therefore, that the decision to consent or not is finely balanced and depends ultimately on the position at the time the payment is due. Neither outcome is entirely desirable. However, provided there is a realistic prospect that the difficulties may be avoided, the negative consequences of a default would probably be sufficiently material that we would wish the Society to proceed to pay the interest as it falls due, particularly following the recent speculation. However, in such circumstances, the [required minimum margin] would probably not have been breached and the issue of consent would not arise.

Conversely, if the [required minimum margin] has been breached on 6 August 2001, it is almost certain that that breach will be accompanied by a solvency breach for company law purposes. In those circumstances, it seems unconceivable that the directors would not have concluded that they needed to initiate formal procedures and that a market statement of the position would have to have been made by [Equitable Life Finance]. In such circumstances, it would seem entirely appropriate for the interest payment not to be made at that point. It would be open to the Society, after a satisfactory compromise of its liabilities, to resume payments at any point in the future.

[22:20] The Director of Insurance forwards the note to the Director of GCD and Managing Director B, saying that he suspected that, at the meeting with Equitable the following day, FSA would not be able to say more than the decision as to whether to provide regulatory consent to the payment was one reserved to HMT. The Director of Insurance says that he thought that ‘much may depend on what confidence we may have in the alternative approach to valuing potential misselling claims which seems to me to be quite crucial to an assessment of the Society’s financial position’.

HMT inform FSA that the Chancellor of the Exchequer holds a policy with a company linked to Equitable (University Life) and so might be conflicted from taking decisions on the company.

FSA’s Director of GCD asks that the Head of Actuarial Support and the Insolvency Practitioner attend the meeting with Equitable that day so that FSA could be clear on what was said by Equitable about their financial position.

[09:37] The Director agrees with the views in Line Manager E’s note of the previous day on the interest payment on the subordinated loan.

FSA’s Chairman reports to the Managing Director of HMT’s Financial Regulation and Industry directorate on a meeting that had just been held with Equitable. FSA’s file note records that:

[FSA’s Chairman noted] that the situation remained uncertain (and further legal and actuarial advice was being sought) but the following points had emerged:

• EL’s Board would be presented on Monday with a range of possibilities for the costs of the misselling liabilities arising from [the Society’s Counsel’s] opinion. Some of these possibilities would make EL insolvent. EL had indicated that this would lead them either to stop paying non-contractual bonuses or to seek liquidation.
• EL had received advice from [their lawyers] that, in liquidation, the liquidator might suspend payments of pensions.
• [FSA’s Chairman] had, as agreed with [HMT’s Managing Director] the previous night, said that there was a chance that HMT might be able to make administration available although no decision to do this had yet been taken. EL had been attracted by this possibility and had agreed to work up a document saying why this would be a better option for policyholders. One possible technical difficulty was identified in that it was possible that the Equitable would not be able to prove to a Court that it was insolvent and would have to risk having the application thrown out. Work would be done to assess the extent of this risk.

FSA’s file note continues:

[FSA’s Chairman] said to [HMT’s Managing Director] that this situation meant that there was a strong possibility that administration was the best option and our strong advice was that they should make it available as soon as was possible. [The Managing Director] said that he accepted that the arguments were very strong but that ministers were not yet convinced. He asked that [the Chairman] set out this recommendation in a letter addressed to [HMT’s Managing Director], which should highlight the point that pensions might not be paid in liquidation. [FSA’s Chairman] undertook to provide a letter this afternoon.

[HMT’s Managing Director] asked whether it might be possible that administration would be required before the tentatively agreed date of 1 August. [FSA’s Chairman] noted that the market situation was fragile and a number of rumours had been circulating. It would therefore be possible that Equitable could be pushed into taking action before that date and conceivably as early as Monday. [The Managing Director] said that it would be practically difficult to make administration available on that timetable but he would see what could be done.

FSA’s note also records that the Chairman had updated the Governor of the Bank of England on the situation, and that: ‘The Governor said that the Bank would stay attuned to whether this was causing any wider impact in the market and would let us know if they heard anything’.

PIA seek advice as they were receiving requests from independent financial advisers for further guidance as to how they should be advising Equitable policyholders and asking about FSA’s attitude to previous advice given. PIA send a copy of their note to FSA. PIA note that it had been suggested in the press that their stance (note: as set out in their ‘Regulatory Update 82’, issued in December 2000) was no longer sustainable. PIA suggest elaborating on the previous guidance and provide a draft question and answer briefing setting out what they had in mind for use by their contact centre.

[16:47] FSA say that they should not deviate from their current line and should refer to the statement issued on 16 July 2001.

FSA supervisors meet to discuss Equitable. The note of the meeting records:

[Managing Director B] reported that he had spoken to [Equitable’s Chief Executive] who had realised himself that administration might not be as good an option as it had appeared in the meeting that morning. [He] had reinforced that view. [He] had also spoken to [Equitable’s Chairman] to say that we thought that they should not rely on administration. [The Chairman] had taken the point but said that his major concern remained whether the Board would be able to sanction the interest payment on the subordinated debt. It was reported that [Equitable] had contacted [a firm of insolvency consultants] and it was likely that they would be providing advice to the meeting on Sunday.

The action points arising from the meeting were:

• A clear and agreed view was needed by the 4pm meeting on Saturday as to what we saw the pros and cons of administration and provisional liquidation to be in order that we could advise HMT. In particular, this would need to highlight what we might realistically expect to happen to annuities payments under each option so we, and ministers, are aware of the likely impact when considering the issue. We should also consider the relative flexibility available to a provisional liquidator versus an administrator – and to ascertain if possible what an administrator’s approach might be in practice.
• We need to consider what the contingency plan would be if [Equitable] goes to court to apply for administration/provisional liquidation and the Court finds that Article 4 of its constitution prevents it from doing so.
• [Equitable’s Appointed Actuary] would be advising the Equitable Board of a ballpark figure for the misselling liabilities on Monday. It was agreed that [the Head of Actuarial Support] would stay close to this work in order to be able to advise us on it.
• A Press Office presence would be arranged for Sunday afternoon. External advisors were on call to test external lines when needed. [The Head of Press Office] would seek to ensure maximum co-ordination of all parties for any announcement.
• Contingency planning would take place over the weekend to prepare press material and consumer help material in case of a possible announcement.
• Consideration needs to be given by the Sunday meeting to whether there are any actions that can be taken to influence the [Policyholder Protection Board].
• The question was raised as to whether any party might be able to provide a letter of comfort to guarantee the interest payment. It was agreed that further thought should be given to how this might work but we should not approach external parties about this until the overall situation could be considered at the Sunday meeting.

FSA send Equitable an extract from their Counsel’s opinion on the calculation of the quantum of liability for possible mis-selling as, although the opinion was provisional, they believed that it might be significant to Equitable’s consideration of the issue. On this, an official has written:

Damages only by reference to loss caused by misinformation, not fund performance  £1.2bn

FSA’s Insolvency Practitioner suggests to the Head of Actuarial Support that he should discuss with Equitable whether mis-selling liabilities could be discounted for the probability as to whether they might arise. The Insolvency Practitioner explains:

Looking at [Counsel for FSA’s] further opinion, he says that a claimant would be entitled to claim compensation for a consequential loss if he can demonstrate that he would have followed an alternative course but for the misrepresentation … It seems to me that policyholders each have their own tolerance for risk. Equitable was regarded (perhaps wrongly) as a highly performing fund but there is a genuine risk and reward assessment that a policyholder could make. Therefore there will be within the mix of all non-GARs some policyholders who have a high enough appetite for risk that they would still have bought Equitable policies. This means that if misselling claims were presented to the society piecemeal and adjudged each on their merits then not all would succeed. There is therefore a basis on which the “realistic cost” of misselling liabilities might be evaluated at less than the “full legal rights” cost.

There is unfortunately, and unlike the GAR take-up rate, no empirical evidence as to the range of risk profiles amongst Equitable policyholders.

FSA meet with a firm of consultants ‘who Equitable were likely to appoint as Administrator or Liquidator if either of those routes were followed’. The key points identified include: that the differences between provisional liquidation and administration were very small; that the risk of rushing an administration order was considered material; that, under provisional liquidation, it was probably possible to make payments to policyholders, but that this might be harder under administration; that Article 4 of Equitable’s Articles of Association could prevent the Policyholder Protection Act 1975 from having effect; that FSA/HMT could put in place measures to mitigate risk by making changes to the Policyholder Protection Act 1975 and could issue a section 45 Order to prevent Equitable from reducing policy values further; and that FSA’s Director of Insurance had spoken to Equitable, who had reported a more optimistic position with regard to mis-selling liabilities, and that the required minimum margin would remain intact.

The action points resulting from the meeting are: that a meeting with HMT would be arranged for 29/07/2001; that FSA’s Director of GCD would speak to HMT to bring them up to speed; ‘[The Director of GCD] to draft outline of argument for’ (Note: this sentence was incomplete); and that the Director of Insurance would speak to Equitable to request a copy of their legal advice.

FSA’s Chairman informs a HMT Director of the outcome of the discussions with the firm of consultants. He says that they had agreed that ‘the top priority was to find a way to allow the Society to continue … making annuity payments and as a contingency ensuring that policyholders would have access to [Policyholder Protection Board] in the event of either an administration or provisional liquidation, therefore guaranteeing that policyholders would receive a minimum of 90%’.

The Chairman says that ‘there appeared to be increasing tension between the Equitable Board – [the Society’s Chairman] in particular appeared to be keen to [throw] in the towel’.

The HMT Director notes that the Association of British Insurers had been clear that it was not the responsibility of their members to contribute to ‘a sweetener of a [compromise] scheme – the issue was to do with regulatory failure’. He also notes that Treasury Ministers were becoming increasingly nervous and the Association’s comments had not helped.

FSA’s Chairman writes to HMT, following their telephone conversation, to update them in writing on FSA’s discussions about the Society’s options that had taken place with Equitable and with their advisers. The Chairman first emphasises that FSA’s top priority was to find a way to allow Equitable to continue to meet their commitments while remaining solvent. Having set out the situation with regard to administration and provisional liquidation, the Chairman turns to Article 4 of Equitable’s Articles of Association:

In brief, if the article has the effect which the Equitable canvass, the amount of its liabilities would reduce with its assets, so it could never become insolvent, and there would be no liabilities to policyholders on which the [Policyholder Protection Board] could pay compensation. We believe that this would be the wrong interpretation of the article. We also believe that this would be a perverse outcome, which would seriously undermine the Policyholders Protection Scheme as a source of confidence for policyholders.

Fortunately, we think that there is action which the government could take to avoid this result. This is because the [Policyholders Protection Board] must take policy values at the amount set by the Insurance (winding up) rules, and there is a community obligation, in the Insurance Winding Up Directive, which would in our view require those rules to operate on the basis that policyholders are entitled to preference over other creditors, rather than on the Society’s interpretation of article 4. There is also action which we need to consider under s45 of the Insurance Companies Act 1982. This might be used, for example, to prevent the Society [exercising] powers under article 4 to reduce policy values below policyholders contractual entitlements.

FSA’s Director of Insurance prepares a ‘rough draft’ of a paper on a proposed section 45 Order to prevent Equitable using powers under Article 4 to reduce guaranteed amounts payable under their contracts.

FSA’s Head of Prudential Policy amends the paper.

The following day, the Director thanks the official for his ‘much better’ paper.

FSA meet with HMT to discuss Equitable. FSA’s note of the meeting records that the key points of the discussion were:

• that HMT would brief ministers on 30 July 2001;
• that there was little difference between provisional liquidation and administration;
• that Equitable’s latest assessment of mis-selling liabilities was £250-500m;
• that, if Equitable proposed cuts in guaranteed values, then FSA would consider intervention under section 45;
• that it was not possible to bring the European Insurance Winding-up Directive into force at present;
• that it would be preferable if publication of the Society’s Counsel’s opinion were deferred.

The actions resulting for FSA are:

• [Head of Actuarial Support] to seek further information about the Society’s estimate of the cost of misselling and the basis on which it had been calculated.
• [Head of Actuarial Support] to provide HMT with some background figures on Equitable annuitants.
• [The Director of GCD] (through [Counsel]) to ascertain if [Counsel for Equitable] supported [his] revised line on how misselling liabilities should be calculated.
• [FSA’s Chairman] to inform [Equitable’s Chairman] before the Equitable Board meeting at 3pm that:
• The differences between provisional liquidations and administration did not appear to us to be significant, unless the Halifax point proved significant.
• That we would have significant concerns about any course of action that reduced liabilities to policyholders in a way that would affect the compensation they would receive from the [Policyholders Protection Board].
• That we feel it would be unwise to publish the [Society’s Counsel’s] opinion without greater clarity about the Society’s financial position (including the results of the [Appointed Actuary’s company’s] work).
• [FSA’s Chairman] to send a letter to HMT outlining our view of the situation following the meeting with representatives of the Equitable at 5pm this afternoon.
• [Managing Director A] to send HMT some material on the potential wider market impact arising from provisional liquidation or administration.

The actions resulting for HMT are:

• To advise whether FSA presence was needed (either at the meeting or on call), for the meeting with ministers tomorrow morning.
• To give further consideration to the interaction between Section 4 and the [Policyholders Protection Act 1975] and what action could be taken to ensure a satisfactory outcome, if necessary.

FSA and Counsel meet to ‘take stock’ on Equitable. Counsel says that he had revised his opinion and that he was now saying that mis-selling liabilities should not exceed the impact on policy values caused by the existence of GARs. It is agreed that, if this calculation were used, then mis-selling liabilities should not exceed Equitable’s free assets at that moment in time. It is noted that, should the market value adjuster be increased to over 10%, policyholders who took benefits at a non-contractual time could be worse off than if a liquidation took place. FSA state: ‘In the event of the Society proposing an increase in the MVA, we would need to give serious consideration to whether this was cause for us to intervene’.

[15:00] FSA’s Chairman speaks to Equitable’s Chairman to, among other things, highlight FSA’s concerns over any reductions in policy values to below the amounts that would be available from the Policyholders’ Protection Board.

FSA’s Chairman reports that Equitable had accepted FSA’s points.

FSA meet Equitable, their auditors, solicitors and Counsel to hear the results of an Equitable Board meeting to consider the way forward for the Society. FSA’s note of the meeting records the discussion.

Equitable’s Chairman summarises the Board’s conclusions:

The Society appeared to be solvent on every basis for calculating solvency.

The Board had been informed of various difficulties which would arise in any of the possible mechanisms for dealing with a potential insolvency. Both provisional liquidation and administration (if that were to be available) would lead to greater loss to creditors than if the Board continued with its current plans.

The Board had concluded that there was no difficulty in paying the interest on the subordinated debt which falls due on 6th August, and would therefore pay it.

The second opinion of [the Society’s Counsel] and the two opinions of [Counsel for FSA], do not entirely agree on the potential for liabilities for mis-selling. [The Counsel who was advising Equitable on the compromise scheme] had offered some useful ideas. The Board was content for all the Counsel involved … together with supporting solicitors, to get together to seek a consensus view on this question. They recognised that it could take until August 20th before [the Society’s Counsels] were in a position to sign an opinion.

Equitable Life would need to do more work to get a better idea of the quantification of mis-selling liabilities. They had received a spectrum of views from [the Society’s Appointed Actuary and its auditors]. The Board had taken a rational, worst case basis for assessing mis-selling liabilities in reaching their decision on the way forward. ([Equitable’s] had indicated to the FSA privately in advance of this meeting that in the Board’s view, this figure was £900m). The Board hoped that further work would show that a better position could be sustained.

The Equitable would press ahead with a Section 425 compromise scheme. The Board wanted to stop “inwards litigation” from policyholder action groups and others. Such litigation could be expected in the period between publication of [Equitable’s Counsel’s second opinion] and a compromise arrangement. [The Counsel who was advising Equitable on the compromise scheme] had advised that there were procedures for dealing with these litigation risks, and that they should ask the Court for them to be stayed pending the 425 scheme.

There would be more regular meetings of the Board, and meetings with their advisers. On occasion, Board representatives might wish to meet with the FSA.

FSA’s Chairman asks several questions, including: if Equitable would prefer administration or provisional liquidation, should things go wrong; whether there was a risk of further policy value cuts; what Equitable would be saying publicly; the effect of surrender levels on cash flow; and about the sensitivity of Equitable’s financial position to stock market movements.

FSA’s Managing Director A informs his Chairman that, after the meeting, he had talked to one of Equitable’s non-executive directors with whom he had used to work at the Bank of England. The Managing Director records:

He is particularly concerned about the following:

a)the terms of Equitable policies [are] so flexible that some two-thirds of the money currently flowing out is not paying the MVA (or financial adjustment as it is now called).

b)this [plus] the impact of equity price falls worries him – he thinks a 5% fall in equity prices would put real strain on their solvency position.

c)he will go on pressing for a significant further reduction of equity holdings. He personally puts the likely outflow in the next 12 months as high as £7bn. So while their short-term cash position is fine, this is going to require continuing positive action in selling equities.

An HMT Director writes to the head of the Chancellor’s private office (copied to other Ministers’ private offices and senior officials). The HMT Director says:

In advance of our meeting with [the Chancellor] tomorrow, I attach [FSA’s Chairman’s] letter to me of this evening and the various notes we prepared today. The notes are unpolished and the exact situation for which they were intended will not now occur. But they serve as useful background for a discussion of the issues. They cover:

• the meeting at the FSA today;
• the article 4 problem and its effect on policy holder protection;
• the effects on policy holders of the various options the [Equitable] Board were considering;
• the pros and cons of introducing an administration scheme;
• a draft statement and possible options for the government’s stance;
• draft Q and As; a note of systemic risk and possible government support;
• a letter [from] the FSA on systemic risk.

HMT’s Director suggests that, at the meeting, the Chancellor considers:

• the current situation. [FSA’s Chairman’s] letter;
• policy holder protection, article 4 and options;
• administration and options;
• the review ([an official’s] submission of [27 July 2001]);
• the case for government support;
• the “package” which should accompany the [Counsel for Equitable’s] opinion’s publication on 20 August;
• in the light of the above, the government’s “stance” and priorities on Equitable.

FSA agree with Equitable that they would have weekly meetings with their Chief Executive and Finance Director. FSA also inform Equitable that Managing Director B or Managing Director A would want to keep in regular contact with the Society’s Chairman.

Equitable send FSA a copy of the proformas for use in the half year accounts and which were to be used in the compromise scheme documentation. Equitable ask that FSA should confirm whether the information was acceptable.

[18:23] Line Manager E seeks comments on whether it is acceptable. The Line Manager says that, following a conversation with Equitable that afternoon, Equitable had been working on mis-selling and had devised a scheme that they would be looking at with their solicitors, and possibly with Counsel, the following day. He says that Equitable planned to put their outline proposals on mis-selling to FSA on 2 August 2001 and to meet on 3 August 2001 to talk them through those proposals.

FSA’s Managing Director A responds to Chief Counsel B’s note of the conversation with Counsel. The Managing Director says that: ‘this is clearly bad news and together with all the noises coming out of the Action Groups strengthens my own feeling that (a) this is all going to have to get tested in Court and (b) there will have to be some process (probably administration) to allow time for that’.

Managing Director A also says that: ‘there is 1 bit in your write-up which seems to me to be surreal and that is where there has been “aggressive selling” or a “positive recommendation to buy a policy.” What on earth is this supposed to mean? Are we now heading for a world in which salesmen for a single company have to hand over a policy saying “I really can’t recommend this policy but if you must have it here it is”?’.

[14:47] Chief Counsel B advises: ‘The problem is that the courts have identified two measures of recoverable loss, one where the advice actually caused the claimant to enter into the transaction, the second (more restricted) where the claimant merely got some information. What [Counsel for Equitable] appear to be saying is that because Equitable employed salesmen and because most of their sales were as a result of advice it may well be possible for claimants to argue that [Equitable] is responsible for all of the “loss” which is consequential upon the advice to acquire a policy i.e including the loss attributable to lower investment performance. There is no suggestion that salesmen cannot advise or recommend’.

FSA’s Head of Actuarial Support says that he did not understand a part of FSA’s Chairman’s letter to HMT of 29/07/2001. The Head of Actuarial Support says:

[Equitable] have made, I understand, and agreed with their advisers and auditors, a best estimate of the liability, taking account of the range of possibilities. It would not in my view be correct to suggest that they would remain solvent in the worst case scenario and I believe that a number of their advisers are aware of this. Indeed, [the Society’s Chairman] did explain to us after their board meeting that the mis-selling provision was being assessed taking account of the basis of quantifying redress as argued in [Counsel for FSA’s second opinion], and not on the basis originally promulgated by [Counsel for Equitable].

[10:08] The Head of Life Insurance points out that the phrase used by Equitable’s Chairman had been ‘rational worst case basis’ and that he had not said on which of the opinions those assumptions had been based.

[10:15] The Head of Actuarial Support asserts that Equitable’s Chairman had said that the Society’s provision (which was less than £900m) had been assessed on the assumption that Counsel for FSA’s second opinion was the appropriate way forward. He agrees that the independent review of mis-selling liabilities would have to produce figures on the two alternative opinions.

[16:27] FSA’s Chairman says that the sentence had been considered carefully but that, if the Head of Actuarial Support had any doubts, FSA must proceed urgently to resolve them.

Further to Chief Counsel B’s note of 30/07/2001 [18:30], Managing Director B says:

What I infer from this is that the “rational worst case basis” referred to by [Equitable’s Chairman] on Sunday afternoon (which enabled the Board to feel comfortable about meeting the various solvency requirements) may not be the correct position – i.e being restricted to [the FSA’s Counsel’s second] basis. As we discussed yesterday we must move as quickly as possible to form our own assessment of the potential range of liability on the [Counsel for Equitable] basis as well as the [Counsel for FSA] basis so we see an “absolute worst case basis”.

FSA’s Insolvency Practitioner circulates a revised draft Notice to Equitable to instruct the Appointed Actuary’s company to assess the quantum of mis-selling liabilities. The Insolvency Practitioner says that the aim was to agree the bases of the assessment internally that day and to discuss them with Equitable and the company the following day.

The Insolvency Practitioner also circulates a draft Notice to Equitable to report certain information monthly and weekly, with the intention of discussing these with Equitable the following day.

[13:08] The Head of Life Insurance identifies two questions which might arise for FSA to consider before the meeting with Equitable.

[14:06] The Head of Actuarial Support provides some suggested changes to the draft letter.

[14:57] The Head of Actuarial Support also says: ‘If we are to monitor their financial condition to the level of comfort being sought at our recent internal meetings here, then I believe that we need the detailed analysis of information on a Companies Act basis as suggested in [the Insolvency Practitioner’s] draft letter. However, given the lesser significance now being attached to the statutory position, then a less detailed summary of the results on the statutory basis could be added to the above requirement’.

FSA’s Head of Insurance Policy writes to the Director of GCD about Article 4.

[16:34] The Head of Insurance Policy later writes to Legal Adviser E about Article 4 and the permitted links regime.

The Tripartite Standing Committee (Deputies), hold an extraordinary meeting to discuss the latest news and prospects concerning Equitable. HMT record the discussion under the following headings.

Mis-selling liabilities

FSA tell the Committee that:

… the Equitable Board had convinced both themselves and the FSA that they could go on making payments and were not insolvent and the FSA had no basis for challenging that.

FSA also report that Counsel for Equitable and Counsel for FSA could not yet reach agreement on the ‘“quantum for redress” ie the basis on which Equitable’s liabilities for misselling should be calculated’.

FSA explain that work was ‘progressing’ on quantifying Equitable’s mis-selling liabilities and that they had required Equitable to commission ‘an independent reporting accountant … to carry out a full analysis of the liabilities on various legal bases’.

HMT’s note records:

[An HMT Director] questioned the statement in [FSA’s Chairman’s] letter of 29 July to him that the FSA had not worked through the quantification of the liabilities with the Equitable. While the regulator was not responsible for Companies Act solvency, in Equitable’s case it was surely worth looking closely at the basis on which the Board had reached its view.

To which FSA reply:

… that it was impossible for the FSA on Sunday to have done anything further to clarify the extent of the liabilities – they could not reach a firm view on this themselves. However, all Equitable’s advisers were satisfied that it was reasonable for the company to continue in business.

FSA also confirmed that ‘the reporting [accountants] … would report on the figures to the FSA as work on clarifying the liabilities on both the [Counsel for Equitable] and [Counsel for FSA] bases progressed’.

FSA add that ‘the Equitable Life Board had looked at the liabilities on both bases on Sunday. The cost on a [Counsel for Equitable] market average comparator basis, was apparently not as great as originally feared. The £3.0-5.0 billion first estimate had been very much a cockshy’.

Fall in equity markets

On the risks to Equitable’s solvency position of further stock market falls, FSA:

… reported that, as of 6 July the Equitable had a Companies Act surplus of just under £2 billion, not taking account of non-GAR misselling liabilities. Some aspects of this valuation might reflect an unduly prudent view but others could reflect an optimistic view. [FSA’s Managing Director A] thought that a further 5% (or 250 point) fall in the FTSE 100 index from current levels could well cause difficulties for the company. If the prices of a major chunk of its assets went down by this amount, the company would be paying out in benefits more than they could afford to do so. They would then have to increase the level of the MVA or take some other steps to rectify the position – which could risk bringing the company down. (It should be noted that because of the flexibility of the terms of Equitable’s policies, MVAs could not be applied in many cases.) The Equitable might also face liquidity problems if the number of policyholders withdrawing their funds was so large that the company had to sell big amounts of securities in difficult market conditions.

The effect of market conditions on the positions of other companies is discussed.

Handling of the publication of the Society’s Counsel’s opinion

Publication of the Society’s and FSA’s Counsels’ opinions is discussed, along with possible FSA guidance on the industry issues.

Options for the way forward

HMT’s note records:

[FSA’s Director of Insurance] said that Equitable believed that, if their proposals for the s.425 scheme of arrangement could be published with the [Counsel for Equitable’s] Opinion, they could secure a stay on litigation until the s.425 scheme had been voted on. There was the possibility under this scenario that policyholders might see the misselling issue as a problem particular to the Equitable rather than a general one. On this basis it could be worth considering what the authorities could do to make it more likely that Equitable could proceed with its scheme of arrangement.

FSA continue:

This broke down into two aspects: ensuring that the company did not become insolvent before the scheme could be voted on; and helping to make the scheme sufficiently attractive to policyholders that they would vote for it. On the former, he wondered whether the government could underpin the company with some guarantee to keep it going – there was a precedent for the government’s doing so in the Pool Re (terrorism insurance) case.

HMT respond that they ‘thought the provision of government funding was a remote prospect. It might in theory be possible for the government to guarantee the Equitable’s liabilities [but] this would raise major moral hazard and other risks and would be very difficult to justify’.

The Bank of England ‘agreed that the question was why Equitable should be underwritten by the government’ and ‘noted that the company itself could hedge itself against further market falls through the use of FTSE put options’.

HMT inform the Committee of their present thinking on the next steps, which was as follows:

• Treasury officials would continue to explore the option of introducing an administration scheme for insurance companies with the Insolvency Service and possibly the [Association of British Insurers] but the Order should be limited to life companies and no public consultation should be undertaken.
• If the Equitable, the Halifax and the FSA were all in favour of administration, the Treasury would probably be inclined to proceed. It would be important however that the FSA should give a clearer view on this …
• The position on Article 4 of Equitable’s Articles of Association remained of concern. We were currently considering what Ministers might say if Equitable did get into the situation where it was proposing to make payments to policyholders lower than they would receive under the [Policyholder Protection Act 1975] scheme arrangements. We needed to establish more clearly what the legal position was and what levers we had at our disposal to ensure the safety net would apply. Discussions with the Lord Chancellor’s Department and the Insolvency Service were ongoing but there looked to be no prospect of changing the Insolvency Rules before 20 August. Indeed, primary legislation might be required, although use of an Order under section 45 of the Insurance Companies Act was being considered.

On this last point, FSA say ‘the risk was that an administrator or provisional liquidator would either not make payments or only do so on a payment on account basis (ie that he reserved the right to recover the payments)’. FSA undertake to provide a note on the issue and ‘any thoughts … on remedies’.

HMT’s note concludes by recording that:

… it was agreed it would be helpful if publication of the [Counsel for Equitable’s ] Opinion could be delayed until more work could be carried out. The FSA could have a power to prevent Equitable from publishing the Opinion, although they would need to consult Ministers on its use. [Director of Insurance] observed that, post N2, the Financial Services Compensation Scheme could take the view that a s.425 scheme offered better prospects for Equitable policyholders than statutory compensation and could make arrangements for such a scheme. If Equitable could be kept going until N2 it could be possible to bring off a s.425 scheme. In conclusion [an HMT Director] said that nothing was being ruled out at this stage.

In response to Line Manager E’s request for comments as to whether the proformas for use in the half-year accounts were acceptable (see 30/07/2001 [18:23]), FSA’s Insolvency Practitioner says that he was not sure that Equitable’s proformas for use in the half-year accounts and compromise scheme documentation told policyholders what they needed to know about Equitable’s financial position. The Insolvency Practitioner explains:

The essence of the compromise scheme is that there is a pot of free assets out of which the cost of meeting GAR liabilities must be paid and the cost of misselling compensation must be paid. Whatever is left in the pot must then remain big enough for the society to have some stability. The “deal” is then how these costs should be borne as between GARs and non-GARs and those missold [and] those not. The costs paid out of the pot reduce expectations of terminal bonuses.

I feel very strongly, that policyholders should know not only the size of this pot (which is the “fund for future appropriations” in the statutory format attached) but also:

• how much of the pot they already expect to get in terminal bonuses (ie the aggregate of the published policy values each policyholder receives);
• how much of the pot GARs and non-GARs (and pre-93/post-93) policyholders could expect to receive before the deal;
• how much is not presently allocated – ie the buffer to provide financial stability.

I think this calls for another pro-forma balance sheet which necessarily will not be in a Companies Act format, and it should show the position before and after the proposed deal. It is likely that after deducting non-guaranteed expectations the society will look insolvent, but this is not necessarily a bad presentation.

The Insolvency Practitioner provides an example of what he had in mind.

FSA’s Line Manager E sends Equitable FSA’s ‘collection of odd points’ about the compromise scheme, on which FSA would like further information.

[16:58] Line Manager E informs other officials that he had done so, saying that most of the points had arisen from FSA’s internal meeting held about a week earlier.

[17:30] The Insolvency Practitioner asks if FSA could agree what information they expected from Equitable and circulates two suggested proformas. He describes the first as being the ‘big picture’ explanation, showing how asset shares were being redistributed under the compromise scheme. The second is a statement for each individual policyholder. On the fairness of a scheme that also compromises mis-selling claims, he says ‘the overall equation should work much more easily since we are back to merely a redistribution of PRE between GAR and non-GAR; however, pre-93 non-GARs close to retirement will still be losers’.

The Policyholder Protection Board’s solicitors write to FSA setting out their views on the scope of the Board’s powers and duties in the event of ‘a pre N2 “default”’.

FSA’s Director of GCD asks Chief Counsel B to take this forward with the Policyholder Protection Board’s solicitors and HMT. The Director of GCD notes that the Board’s solicitors had not given a final view on Article 4 of Equitable’s Articles of Association ‘but note that its effect is that the Board “may not be empowered or required to exercise its powers …”’.