October 2001

FSA’s Director of GCD asks Chief Counsel A whether he was correct to assume that no legal advice had been sought or given on a particular clause in the reinsurance treaty.

Chief Counsel A replies that only preliminary advice had been given, as was summarised in her note of 28/09/2001 recording her discussion with Counsel, which she attached. The Chief Counsel says that: ‘We await a copy of Equitable’s final advice. Not much hangs on it in the sense that they will have to persuade us that the reinsurance will count for more than £100m’.

FSA arrange to meet Equitable later that week. FSA say that they believed that a meeting was necessary to review Equitable’s financial position in the light of:

(1) the responses that your colleagues promised to points raised at last Friday’s meeting, namely:–

  
• the update on the status of the Reinsurance Treaty; and
  
• a more considered analysis of the liability for potential mis-selling (taking account of the liability to those who leave before a scheme is in place, and the fact that in the absence of a scheme it is difficult to see how the same discount can be allowed as under the scheme, where non-GAR policyholders would be paying for about 75% of their own compensation); and

(2) in the light of your responses to the questions in my letter of 26 September about the impact of stockmarket falls.

[10:13] The Director of Insurance confirms that this was the case. The Director explains that FSA were awaiting a detailed justification from Equitable of their own assessment. The Director says that he understood that the Society’s assessment ‘indicates that they continue to meet their [required minimum margin] even on “worst case” assumptions about the impact of the side letter’. The Director of Insurance continues by saying that Equitable’s ability to continue to meet their required margin of solvency:

… depends, among other things, on the reserve to be set up to cover misselling costs absent a compromise, on which [the Head of Actuarial Support] has been working with [Legal Adviser F]. On the Society’s figures there is some room for increasing the reserve from what they believe appropriate, but it is quite tight.

The Director of Insurance also raises an issue of separate concern that payouts on maturity might still be greater than asset share. He notes that Equitable ‘naturally, are not keen to announce a further reduction in policy values at this point since they judge that this would damage, probably fatally, their chance of gaining agreement to the compromise’.

[12:03] In reply (but not to the Chairman), the Head of Actuarial Support circulates his estimate of mis-selling liabilities, which is dated 1 October 2001. The Head of Actuarial Support says it was:

… likely that the Society is still solvent, and it may still just be covering its margin of solvency, but there remains fundamental uncertainty relating to the amount of these mis-selling claims, the proportion of the claim that would be guaranteed, the number of potential leavers (for whom all the claim would have to be paid in cash), and the possibility of sizeable claims arising instead under the heading of recission of contracts.

On current payouts, the Head of Actuarial Support says:

… I would estimate that the claim values paid on contractual events are around 5-7% too high at present. The free reserves in the balance sheet seem to be falling by around £200 million every month, mainly as a result I believe of the payment of final bonuses on claims for which there is no provision on the balance sheet.

The Head of Actuarial Support’s note of an estimate of Equitable’s mis-selling provision at 30 September 2001 states that the required provision should be:

Policies written since January 1996 £180m

Policies written between 1988 and 1995 £200m-£400m

Leavers between June 2000 and 16 July 2001 £20m-£60m

Leavers since 16 July 2001 £40m plus a further £50m-£100m

Claims for recission of contract £100m

The Head of Actuarial Support’s note concludes:

The overall accounting provision for the above headings, after taking account of the probability of success could then be around £300-550 million, with a best estimate likely to be in the range of £400-£500 million. For the FSA returns, we would expect to see a greater margin for prudence, and probably a contingent liability for potential recission claims, which might indicate a provision of between £600 and £700 million.

Equitable send FSA the latest draft versions of the Combined Scheme Document, Indicative Statement of Value and Proxy Forms, ahead of a Creditors’ Pack drafting meeting on 5 October 2001.

[16:19] The Head of Life Insurance circulates the documents and asks for comments by 4 October 2001.

[18:46] FSA’s Insolvency Practitioner says that there were three key pieces of information which had been missing from the Combined Scheme Document, those being: aggregate policy values; background to the policy value reductions; and value of GAR rights being given up. He also says that it was to be welcomed that: ‘The Article 4 issues are explicitly addressed and it is made clear that there is no certainty that the [Policyholders Protection Board] would respond if the Society were wound up’.

[19:28] An official from FSA’s Consumer Relations Department endorses the points made by the Insolvency Practitioner.

[20:11] The Director of Insurance says that he was not sure that the information on Article 4, and there being no certainty of compensation from the Policyholder Protection Board, was  to be welcomed. The Director says that he would be concerned if the uncertainty were to be overstated.

Further to 02/10/2001 [20:11], FSA’s Head of Life Insurance explains that the Article 4 point had been included to meet FSA’s earlier comment that the implications of the alternatives should be clearly spelt out, although: ‘I’m not sure that Article 4 was what we had in mind!’.

[13:15] A Press Office official says that she had mixed feelings about the Article 4 information:

On the one hand, some openness about the possible non-applicability of the [Policyholder Protection Board] is, in principle, to be welcomed.

On the other hand, it will make us, [Policyholder Protection Board], [the Financial Services Compensation Scheme] et al appear disingenuous for not previously drawing attention  to it.

Our defence has to be that HMT intends to correct this. Provided this is true, then it might be best not to flag it. – Not least because, in the current environment, it might just cause panic in the meantime re other insurers if people fear that they would also not be covered by [Policyholder Protection Board]/[the Financial Services Compensation Scheme] if other insurers should collapse if the equity market were to shoot down further.

So there might be a market confidence argument for not drawing attention to it.

But if [Policyholder Protection Board]/[the Financial Services Compensation Scheme] could say something helpful about how most companies would be covered by their schemes (even [though] they don’t customarily comment at all on general cases, but treat applications for compensation on a case-by-case basis), that might help square the circle.

It would mean that Equitable could disclose the Art 4 issue; we could say that we were aware but that HMT intended to resolve the issue; HMT would endorse this; and if anyone asked about the general applicability of [the Financial Services Compensation Scheme] etc, they would reassure people re their general coverage of other insurers in the meantime.

If we could arrange this, I think I would tend to favour disclosure in the interests of transparency. If any of those pieces of the jigsaw don’t fall into place, I would be inclined, on market confidence grounds, to discourage Equitable from disclosing the issue until HMT does something about it.

[14:24] The Head of Actuarial Support provides various comments on the Creditors Pack documentation, including that: ‘there are numerous inconsistencies in the drafts about the value to be attributed to the Halifax payment for GAR’s and non-GAR’s. I still do not understand why proportionately more of this (as a percentage) is being given to the GAR’s than to the non-GAR’s!’.

[19:46] Chief Counsel A replies to the Press Office official, saying that: ‘[Article] 4 is difficult. In terms of principle it is hard to argue against letting the [Equitable] say something about it. But the public reaction to just about anything they say will be astronomically out of proportion. Unfortunately I do not think we can say that HMT intends to correct the problem … I recall HMT think the issue would need to be resolved by the Courts and have said they would not do anything in advance of that. I do not think however there is a market confidence issue (if things are handled properly) because it seems almost certain that the [Equitable] is the only one affected by the [Article] 4 problem’.

[21:40] The Director of Insurance reports that he had spoken to the Chairman of the Policyholder Protection Board who had told him that the Board would not wish to argue that Article 4 was an impediment to compensation, but that they would probably want to invoke the excessive benefit provision of the Act.

Equitable’s Finance Director replies to FSA’s note of 02/10/2001 [10:38]: ‘I have not spoken to [the Appointed Actuary] since your email, but the comment was in the context of what would our position be if the reinsurance treaty is not available. Our lawyers still assert that we can probably rely on the treaty. We are seeking clarification urgently and will apply for a s 68 concession if necessary’.

[19:18] The Head of Life Insurance forwards the response to the Director of Insurance (copied to others) with the comment: ‘So there!’.

Further to Equitable’s reply of 03/10/2001 [15:32], the Head of Actuarial Support comments that:

In view of the letter apparently received from IRECO saying that they would intend the treaty to be cancelled if the claim ever exceeded £100 million, I think it would be very difficult for Equitable to take credit for more than this amount in a “prudent” statutory valuation, where the actuary has to take account of both the credit and legal risk under this reinsurance agreement.

[10:29] Chief Counsel A agrees with the Head of Actuarial Support, subject to seeing the advice from Equitable’s solicitors.

FSA send Equitable’s advisers their high level comments from a preliminary scrutiny of the latest drafts of the compromise scheme documents. FSA say that there were three important pieces of information which policyholders should have but which did not appear to have been included, those being:

1. Aggregate Policy Values

The launch document stated that “since the policy value reductions in July 2001 … aggregate policy values and the value of the investments underlying policies are now broadly in line. Information in respect of this and other financial matters will be available in the interim financial statements for the six months to 30th June 2001”. Will this include aggregate policy value information? The financial position of the society, and material movements since 30th June, will need to be adequately disclosed. In assessing the value of their uplifts to policy values, policyholders need to know what the Society’s position is on further possible cuts to policy values.

2.Background to the 16th July Policy Value Reductions

The launch document said that the Society intends to issue a booklet containing the background to the policy value reductions when revised policy value statements are sent out in October. Will this be sent out separately from the Creditor Pack?  We should like to see a draft of this booklet please.

3. Value of GAR rights being given up

We think that policyholders need to understand the difference between GAR rates and CAR rates, in order to be able to assess the value to them to the proposed policy value uplift. (In doing this, they will of course need to take into account the value to them of greater stability, greater flexibility in the terms of annuities available, etc – but they need to be able to start from the value of the GAR rights being given up).

FSA also say that they were looking forward to seeing the draft of the Appointed Actuary’s report and the financial information described in the documents. FSA say that they were still thinking about the material on Article 4.

An FSA official writes to the Head of Actuarial Support, the Director of Insurance, the Head of Life Insurance and Line Manager E about a proposal from Equitable to write new business (see 19/09/2001 [entry 1]) where a policy had been split due to divorce. [11:30] The Head of Actuarial Support, [12:08] Line Manager E and [13:16] the Head of Life Insurance agree that the proposal seems reasonable.

On 07/10/2001 [16:28], Chief Counsel A says that she does not intend to provide advice on this issue unless she had to, adding: ‘I doubt it is necessary, assuming you are content as a matter of policy that Equitable be “permitted” to do what it suggests …’.

Equitable write to FSA saying that they would need FSA to provide a formal statement on the compromise scheme to the convening hearing planned for 1 and 2 November 2001. Equitable ask FSA to confirm that the provision of such a statement appeared feasible.

[19:50] The Head of Life Insurance says to Chief Counsel A that he presumed that this was not a requirement of the scheme but believed that FSA would in principle be willing to express a view to the court at that stage.

FSA’s Line Manager E sends the Head of Life Insurance, the Director of Insurance and the Head of Actuarial Support a list of points to raise with Equitable at the meeting on 08/10/2001, including:

• to ask for a reply to FSA’s letter of 21/08/2001 about Equitable’s 2000 returns and also on their request for a future profits implicit item;
• the ‘synthetic bond’ as FSA ‘had to return to the question of whether going forward we would look for consistency with 2000 or the rest of the industry’;
• in relation to the FSA’s Consultation Paper 84 and the proposals in the Interim Prudential Sourcebook to update requirements on the methods and assumptions to be used in actuarial valuation of long term insurance business, FSA should be ‘mindful that it could impact on the value of the implicit item for future profits, we should ask whether they intend to ask for a section 68 order for this or not’; and
• in relation to ‘Policy statements’, Line Manager E says that he: ‘spoke briefly to [an Equitable actuary] who said that they were still expecting to be able to issue policy value statements “this month”. Back in June/July they said that the systems would be interrupted for 6 weeks, though 10 have already passed and we are now getting a lot of complaints. The media have also picked up on this. We need to urge them to get on with this, and also find out what the position is with online and telephone valuation requests – ie are they now available, and if not when will they be back on stream’.

Equitable provide FSA with an update on Equitable’s solvency position on three different bases, in response to their letter of 27/09/2001. The information is provided at the request of Equitable’s Appointed Actuary. The information is based on the estimated position at the end of 24 September 2001. Equitable explain:

The three bases of presentation are:

1. Our normal presentation assuming a full resilience test based on “test 2” of the GAD letter dated 14 May 2000 and taking no account of any measures that that might improve the free assets in the short term. This takes into account the full effect of the reinsurance treaty for GAR liabilities.

2. A presentation which assumes no resilience falls in the value of equities or property and also makes some estimate for the improvement for the N2 yields on equities. Again the full effect of the reinsurance treaty for GAR liabilities is taken. Please note that in such a circumstance the future profits implicit item would reduce to close to zero.

3. The same as 2. above but showing the effect were the reinsurance to only be valid up to £100m.    

Equitable state that the figures include a provision for mis-selling of non-GAR policies of £220m. Equitable explain their rationale for this level of provision is as follows:

The Society has received legal advice from [Counsel] that non-GAR policyholders may have claims against the Society because they were not warned of the extra potential costs of GARs when they bought their policies. The total amount of all potential claims has been estimated on an aggregate basis to be £850m (following the bonus changes at 16 July 2001).

However, not all these claims are likely to be successful. The range of probability of success of those potential claims, when taken as a whole, has been estimated by the Society’s legal advisers to vary widely from perhaps 20% to 70%.

Around 75% by value of the Society’s with-profits funds is owned by non-GAR policyholders. Successful claims would mainly have to be met out of the with-profits fund. Consequently around 75% of non-GAR policyholders’ claims could end up being paid for by non-GAR policyholders themselves. There are differing legal views on whether, if claims were able to be framed in a certain way, this would still be the case. The extent of the claims that would in effect be paid for by non-GAR policyholders themselves would be up to 75% depending on which legal opinions were followed.

The provision for potential claims has been determined assuming that in the absence of a successful compromise scheme under s425 of the Companies Act (as proposed by the Society) that the claims will be resolved through a review instigated by the Pensions Ombudsman or the FSA under PIA rules. It is assumed that such a review would have a defined basis of assessing the damages for any individual case which would take into account all relevant factors including the extent to which non-GAR policyholders would pay for the claims themselves.

The total estimated value of potential claims on an aggregate basis of £850 million has been discounted to reflect the probability of success (between 20% and 70%) and because non-GAR policyholders would bear part of the cost of the claims themselves (between 0% and 75% but estimate to be between 25% and 65%). The Board has taken the view that the likely value for potential claims lies in the range of £100 million to £300 million. A provision for the cost of potential claims from non-GARs has been set at £220m.

FSA’s Director of Insurance says that he agreed with Chief Counsel A’s comments of the previous day, saying that he imagined:

… the Equitable may want us to express support for the “two classes only” approach, with which we may have some difficulty. I doubt whether at this stage we can commit to much more than the view that the promotion of “a” compromise scheme is an appropriate way forward. I guess the court may also be interested in establishing a view on solvency where I guess we are still in the “fundamental uncertainty” position.

[18:51] The Head of Life Insurance later responds that, on reflection, he had got ‘cold feet’ over the weekend and that FSA covered this issue on very non-committal lines at their meeting with Equitable that morning (see below).

FSA meet Equitable for a weekly review meeting. According to FSA’s note of the meeting, discussion largely focused on Equitable’s letter of 05/10/2001 and the issues arising from it.

Equitable give an update on the position with regard to the reinsurance treaty: IRECO had indicated that they would provide a revised agreement by 11 October 2001; and Equitable had made it clear that the issues needed to be resolved by 18 October 2001, in time for the compromise scheme. Equitable agree to provide FSA with a copy of their legal advice on the effect of the side letter.

FSA note that, under scenario 3 of the solvency information supplied by Equitable, there were no free assets over the required minimum margin and that no resilience reserve had been provided for, having assumed that a section 68 Order for a ‘CP84 concession’ had been granted (although an application had not yet been made).

FSA ask for justification for the provision of £220m for mis-selling and for further information on the quantification, provisioning and extent to which such claims could be recovered from policyholders.

On the financial condition of the Society, Equitable say that they were working with their auditors on a half-yearly financial statement for use with the compromise scheme. Equitable take FSA through the solvency presentations set out in their letter of 05/10/2001. FSA say that, if Equitable wanted a section 68 Order, they should submit an application as a matter of urgency.

Equitable say that policy values were not significantly out of line, reporting to FSA that: ‘At the stock market lows, aggregate values stood at about 105% of the value of the with-profits fund, but they were now back to around 102% following the modest improvements’. Equitable’s Appointed Actuary ‘said he was clear of the need to act if policy values became excessive once again, though he was alive to the sensitivity of this and also the need not to give any public indication of the kinds of level at which he thought action would be needed as this would enable policyholders to select against the fund’.

On Article 4 of Equitable’s Articles of Association, FSA invite the Society to provide a copy of the advice received from Counsel so that the arguments could be properly tested. FSA also suggest that Equitable should discuss with the Policyholder Protection Board and/or the Financial Services Compensation Scheme ‘as their approach to compensation could be very relevant’.

Equitable inform FSA that the court convening hearing for the compromise scheme had been set for 1 and 2 November 2001. They undertake to provide further details on a query about the weighting arrangements for the policyholder classes which had been raised by solicitors acting on behalf of non-GAR policyholders.

FSA’s Head of Life Insurance writes to Managing Director B, following the meeting with Equitable that morning, about the public line that FSA should be taking as the ‘ability of Equitable Life to meet its required minimum margin of solvency is now seriously in doubt’.

The Head of Life Insurance sets out their latest understanding of Equitable’s financial position, following their letter of 05/10/2001 and the meeting earlier that day. He says that FSA proposed to seek Counsel’s opinion on what a reasonable range for mis-selling provision would be. The Head of Life Insurance says that:

In these circumstances, we need to consider carefully what the FSA’s public position should be. At present in answer to the question “is the Equitable solvent?” press office have been giving the answer (and the same answer is contained on the FSA website):–

“We have been monitoring Equitable Life’s financial position closely, and on the basis of the information available to us, we are satisfied that it continues to meet its regulatory solvency margin requirements. Nevertheless, Equitable Life made clear in its annual accounts and in its regulatory return (a report that [they] must make to us), that it continues to face some fundamental uncertainties – for example, in relation to the cost of its liabilities to the Guaranteed Annuity Rate (GAR) policyholders. The proposed compromise scheme is designed to address those uncertainties.”

The Equitable’s solvency is not in question. But there is now a serious question over whether it continues to meet its required minimum margin of solvency.

FSA’s Head of Life Insurance says that there was a case for leaving the line unchanged until the position on the reinsurance treaty and quantification of mis-selling liabilities had been clarified. He notes that any change was ‘bound to attract attention, and could undermine confidence in the Society at a delicate stage in its attempt to secure a compromise scheme which we believe will be in the best interests of all policyholders’; however: ‘It is not clear that the required minimum margin has been [breached]’. The Head of Life Insurance continues: ‘On the other hand, there is sufficient doubt about the position to make the present line difficult to sustain. What is new is that we now have (confidential) information which throws doubt on the credit for £700 million claimed under the Reinsurance Treaty. We are not yet in a position to reach a view on this’.

The Head of Life Insurance suggests that FSA should think seriously about removing the relevant page from their website as an interim measure until the position had been clarified (noting that ‘This can be explained as being for updating’). He also suggests reviewing the line taken in response to press queries.

Line Manager E asks the Head of Life Insurance, the Head of Actuarial Support and Chief Counsel A for comments on a draft letter to be sent to Equitable requiring them to submit a plan for the restoration of a sound financial position. The Line Manager says:

Since our discussion earlier, I am becoming more dubious about whether or not we have the powers to require the production of a plan. I also think that by asking for a plan, we will as [Chief Counsel A] pointed out cause some irritation that might be counterproductive, and lead to the resending of the draft s.425 scheme documents.

So instead I have tried an approach that says that there may well have been a breach; that we are aware that the plan is under development, but we need to keep [an] eye on the position until the plan is adopted, or in case it is not adopted at all. And that approach is to confirm the information that we have requested and they agreed to provide.

[22:07] Chief Counsel A comments:

Just to be clear, I think we do have the power now to require a plan. ELAS are almost certainly underprovisioning for both misselling and resilience.

The following day [at 09:55], FSA’s Head of Actuarial Support adds:

I would concur with this view based on the information as set out in the letter of 5 October from [Equitable] with which [Equitable’s Appointed Actuary] appeared to concur at his meeting with us yesterday (though in relation to scenario 1, there was a resilience provision but no allowance for the legal risk on the reinsurance agreement).

[12:38] Line Manager E says that the: ‘position on 24 September seems clearer than the position today, given that my back of the envelope calculation suggest that the value of their equities is currently £1 billion higher. Is it right though that the test is whether there has (at any time) been a breach of the [required minimum margin] rather than whether the breach is continuing?’.

[12:56] Chief Counsel A suggests that: ‘the power applies to past or current failures, but discretion must then be exercised by FSA as to whether a plan ought to be requested. It would eg arguably be disproportionate if there had been only a “technical” breach which was quickly rectified’.

Equitable send FSA copies of the latest progress report on the production of Equitable’s Creditors’ Pack.

Line Manager E circulates the report the following day [at 09:42].

An FSA official circulates documentation in relation to the compromise scheme.

Over the following two days, FSA officials discuss some of the terminology used in the documentation (including the term ‘policy value’) which they regard as potentially ambiguous.