November 2001

FSA’s Director of GCD asks Chief Counsel A what advice, if any, had been given in response to Equitable’s plan for the restoration of a sound financial position (see entry for 26/10/2001 [09:57]).

[10:21] Chief Counsel A replies that, on point 1 of the Head of Actuarial Support’s list of fundamental uncertainties (see 25/10/2001 [14:13]), the clear advice had been that credit could not be taken in the returns for the reinsurance of more than £100m, until the uncertainty was removed. She says that point 7 was to be considered by Legal Adviser F and Chief Counsel B, who were on leave.

[14:42] The Head of Actuarial Support comments that it does not seem to be a very well-informed paper ‘but does include some useful pointers’, which he goes on to describe. Under the heading ‘Accounting for GARs’, he says ‘the accounting rules do not require explicit provision to be made for future discretionary bonuses, though some implicit provision is still made through discounting the liabilities at a very low rate of interest’

[FSA’s Director of Insurance] replied that there was no formal approval role. Our locus was that we would need to be satisfied about the integrity of the treaty when assessing the credit taken for it in the solvency calculations. For the same credit to be taken we would need to see that after the negotiations it provided the kind of protection that we had always understood that it provided. [IRECO’s parent company] said that the treaty was always intended to be a riskless transaction. [The Director] said that that was very definitely not our view at the time, on the basis of the information we were given, since there was a clear risk for Ireco on the terms we had seen in the event the [projected] surplus did not emerge. Had there been no risk transfer, the treaty could not [have] been taken into account in the solvency calculations.

On disclosure of any amendments to the treaty, the note records:

[FSA’s Director of Insurance] noted that if the result of the revised terms was a substantial change in the terms of the treaty, we believed that proper disclosure of the facts by the Society of the changes and the surrounding circumstances would be required by us and probably by the Society’s auditors. [He] added that if the changes were less dramatic, and amounted to little more than a clarification of the terms, then there might be less need for disclosure.

The effect of the change described … is generally to reduce the liabilities of life funds which hold equities. For companies whose solvency is tight, the relief could be material to their maintaining statutory solvency in a falling equities market. In current market conditions it is desirable to allow companies in this position to take the benefit of the relaxation now, in order to reduce pressure on them to sell equities for technical reasons (ie to maintain statutory solvency on the current valuation basis), as such technical selling would further depress equity values, and thus compound the problem across the industry …

Equitable Life estimates the effect of the change to the equity yield calculation will result in an improvement in the Society’s free assets of about £200 million.

FSA recommend that the section 68 Order, which they say ‘is consistent with the other equivalent Orders granted for other life offices’, should be granted.

FSA meet Equitable to discuss the compromise scheme.

Following the meeting, Equitable’s solicitors send FSA the text of the provision in the agreement with Halifax which said that, for the further payment of £250m to be made, requires FSA to have ‘confirmed that it has no objection to the Proposed Scheme or to the draft Scheme Documents being issued to creditors entitled to vote thereon’.

FSA’s Director of Insurance informs the Head of Life Insurance of two telephone conversations with Equitable (at 17:30 and 18:30) about the negotiations on the reinsurance treaty. He sets out, in broad terms, his understanding of the revised terms of the treaty, as they currently stood in the negotiation process:

Ireco accept that the side letter is to be treated as if it had never been issued, and could at no time have been relied on … by them.

An addition to the Treaty is to be made as from 1/12/01. This will deal with the (arguably improbable) situation where claims under the Treaty exceed £100m, where at present the Treaty simply provides for “renegotiation”.

The addition will provide that protection will be provided up to a defined limit (of around the £700m for which credit is taken for reserving purposes +20 -20% of that amount). The intention is that the limit should be sufficient to satisfy us that the full £700m credit can be taken.

The Director reports that he had told Equitable that:

… [he] was pleased that it appeared that a satisfactory solution might be in sight. But they had to understand that we would have to scrutinise the proposal very carefully before we could confirm that it could be allowed to “count” for solvency purposes.

Equitable Life has applied for two concessions relating to the valuation of certain of its assets. Such concessions are granted by the Treasury under section 68 of the Insurance Companies Act 1982, taking into account the advice of the FSA. Both issues have been looked at by the Insurance Supervisory Committee and senior management of the FSA. This paper reflects the FSA’s view. We recommend that the appropriate section 68 order[s] be made.

On the section 68 Order relating to Permanent Insurance, the official says:

The normal approach taken when valuing a shareholding in a private subsidiary company is to use the “look through” value. That produces a very conservative valuation. On that basis, the then subsidiary of Equitable Life would be valued at around £30 million. However, Equitable Life agreed on 22 December 2000 to sell Permanent to Liverpool Victoria for £150 million. The deal was unconditional, other than for regulatory approval, and was completed on 16 February 2001. Equitable Life believes that for the purposes of the 2000 year end returns, it should report the value of the subsidiary on the basis of the agreed sale price.

We consider that as the sale was confirmed, the agreed sale price provides a sensible basis for a valuation of this asset and is consistent with the treatment in the Companies Act accounts. We believe that the equivalent concessions, requiring a proven market valuation to be used, have been given in other similar circumstances. It is also not unusual for a requirement to report on a particular basis to be imposed after the event, provided that the requirement is imposed in advance of the reporting date.

On the section 68 Order relating to rates of interest, the official explains:

Regulation 69 of the Insurance Companies Regulations 1994 specifies the basis on which future payments are to be valued. In effect, the requirement is to assume an interest rate no higher than the average yield currently being achieved on the assets supporting the long term business. The regulation specifies how that yield is to be calculated. However, there is a slight defect in the averaging method prescribed in the regulations which means that depending on economical circumstances they can place (and at the moment they are placing) an artificial strain on the company. In other economic circumstances it can lead to an artificial release of reserves. This arises because of the simplistic basis of the calculations for fixed interest assets, which averages the rates [of] interest by [the] value of the underlying investments, but takes no account of … their duration. At the time the regulations were made, more sophisticated calculations were not thought necessary.

The problems with the valuation method in regulation 69 become evident when doing the calculations for resilience tests. Many companies just live with the consequences. However some (including [two named companies]) have preferred to report more accurately and have therefore sought and been given section 68 orders requiring them to perform more sophisticated calculations. Equitable Life has asked for a similar concession. The proposal is to calculate the yield on the basis of two segments of fixed interest securities (approved and non-approved). We consider this approach to be perfectly valid and would support other companies wishing to adopt it. However, the methodology is slightly different from that which has been applied by other companies. The alternative effectively involves the company seeking to hypothecate blocks of fixed interest assets to particular areas of business in order to calculate the yield.

There will be a need for a continued concession under section 68 (or a waiver to the equivalent FSA rule) going forward. At this stage however we are recommending that the concession granted should deal only with the reporting of the end 2000 position. This produces a more accurate reflection of the financial position than would be the case if it followed the requirements of regulation 69 and granting the order will enable the Society to complete its annual returns for 2000.

We will wish to discuss the future arrangements further with the Society. This is because the Equitable has now concluded that in future it would be able to do the calculations on the basis followed by [the two named companies]. It is not possible for them to produce the 2000 year end figures on that alternative basis because of the complexity of the calculations involved. However, there are issues we will want to consider more carefully before agreeing to that because the nature of the business of those companies is different and we also look to companies to maintain consistency of valuation methods from one year to the next. We have not yet reached a firm view on the appropriate treatment going forward.

However, as background, we have discussed the effects of the alternative valuation methods to that required by regulation 69. Equitable has indicated that (at least with current economic conditions) the financial effects of either methodology would be broadly similar, although the method adopted by [one of the named companies] might produce a very slightly less favourable result. If Equitable Life goes ahead on the basis it had proposed the benefit to its solvency position will be of the order of £150-200 million as compared with the regulations. The company’s actuary believes that the … method [adopted by one of the named companies] would also have produced a benefit within that range.

FSA’s Chief Counsel A provides the Director of GCD with a note on the issues within the compromise scheme proposals concerning uplifts to the policyholders of both GAR and non-GAR policyholders, which she hopes ‘can form a starting point first for instructing Counsel … and then for the matters which the FSA will need to address to the Court (and perhaps before then to policyholders)’. Chief Counsel A sets out the issues as follows:

In relation to the GAR policyholder uplifts, the Chief Counsel says:

From page 83 of Draft 4A (15.10.01) of the Scheme of Arrangement … examples of how the scheme will affect policyholders are set out. Examples 1 and 2 illustrate that the same up-lift will attach to the GAR guaranteed value (basically premiums minus costs etc plus annual bonus) and GAR policy value (which should be very close to asset share). Thus the uplift will attach proportionately to the guaranteed and non-guaranteed parts of the policy value which seems appropriate. The Halifax uplift of 1.3% attaches only to the policy value since it is not guaranteed. This seems fair even in cases where those whose guaranteed amount is higher than policy value will potentially lose out because Equitable paid out too much to them in previous years by way of guaranteed annual bonus.

In relation to the non-GAR policyholder uplifts, she says:

Chief Counsel A also says:

On page 129/130 the “after the uplift” percentage without the Halifax £250m is lower than the “before the uplift” percentage. I do not know why (and see also page 132).

We need to confirm that Equitable are proposing to calculate policy value for voting purposes by taking either the guaranteed amount or policy value (whichever is higher), and in the case of GARs, adding the uplift (as a proxy for the value of the GAR). The draft creditors pack is not clear.

We have already indicated that the FSA is content with the size of the pot for the GAR uplift, but more work is needed on the analysis of the impact of the uplift for relevant groups of GAR policyholders. More work is needed too on the size of the non-GAR misselling pot and whether a uniform uplift is fair.

HMT’s Director of Financial Regulation and Industry informs an HMT official of a conversation with FSA (the Director of Insurance, as Managing Director B had not been available). The HMT Director’s note records that the FSA Director had:

… said that FSA had written to [Equitable] shortly after [September] 11 to ask them for a recovery plan as they appeared to have breached their solvency margin. (This did not amount to insolvency.) The letter you’ve just seen is presumably this. [Equitable] disputed the position. The FSA’s view assumed the “side letter” to the reinsurance agreement meant the reinsurance was worth a max of £100m.

[FSA’s Director of Insurance] also said that [Equitable] had subsequently negotiated an additional premium they would pay if claims covered by the reinsurance agreement exceeded £100m. On this basis the side letter was regarded as “never having existed”. (I commented that [Equitable] had in effect bought their way out of the side letter; [he] disagreed although acknowledged he was perhaps making a distinction without a difference.) [He] felt that on this basis [Equitable] had never breached its margin, and was certainly not currently breaching its margin, although he added there remained uncertainties about provisioning for mis-selling. When pressed, he also added that FSA had not yet seen the [revision] of the reinsurance agreement.

Lets discuss on Monday. Regarding Baird I’m re-inforced in the view that we must look to the FSA for advice on s68 orders as they cannot be judged in isolation, but [especially] given [the Baird Report] I’m equally sure we need to be crystal clear what the FSA advice is and that they’ve considered the situation properly before giving it. We’ll probably need a session with FSA early next week on this.

FSA’s Director of GCD comments on the reinsurance treaty: ‘Don’t think it helps much to put in place a riskless deal for the future-hope that’s not what’s intended’. He asks whether FSA should write to other companies, seeking confirmation that there were no side letters to their reinsurance agreements.

[10:41] In reply, the Head of Actuarial Support says that FSA were about to write to another insurance company which had an almost identical reinsurance treaty with the same reinsurer to ask ‘some searching questions’. On other companies with similar reinsurance agreements, he goes on to say: ‘Most of these though include Ireco as a partner with other reinsurers … in these arrangements, and generally [they] seem to be documented rather more fully’.

Reinsurance

Equitable report that a verbal agreement had been reached and say that they would, in due course confirm the full details of the proposals. The note records:

[FSA’s Director of Insurance] asked about their proposals for disclosing the recent events, suggesting that it might be wise to be reasonably open about what had happened and setting out what the Society had done when it had identified the problem. [The Director] pointed out that this was bound to come out at some point and failure to give adequate and managed disclosure now might lead to accusations later. We also discussed what effect the proposed treatment of the side letter might have when assessing whether or not [there] had been a breach of the solvency margin. [Equitable’s Finance Director] acknowledged that this was awkward and said he would consider it further for the purposes of the statutory returns and the accounts. He noted that the Society no longer referred to compliance with the regulatory requirements and now only talked of being solvent.

Financial condition

In response to FSA’s Head of Actuarial Support, Equitable say that they agreed that the end-October solvency position appeared tight. Equitable comment that they had sold £1bn of equities in October, reducing the equity backing ratio of the with-profits fund to 49% (including property).

In response to a question by FSA about the ratio of policy values to asset values, the note records that:

[Equitable] said that this was last reviewed at the end of October when the FTSE 100 was at 5050. At the time, maturity payouts were at about 103-4%, and early surrenders at about 93%. This meant that overall, departures were taking about 98% of their share of the assets. He said that [they] would review the position if aggregate policy values reached 105% of the asset value. [FSA’s Director of Insurance] said we had a particular concern … to ensure that policyholders would not be asked to vote on the scheme on the basis of misleading information about the value of the company.

Halifax Equitable Clerical Medical

The note records that Equitable had informed the FSA of ‘serious problems’ in their relationship with Halifax Equitable Clerical Medical, and ‘that there was even a risk that the compromise would have to be either delayed or abandoned’.

Section 425 scheme

Equitable provide an update on progress on the compromise scheme and confirm that the court hearing was set for 26 and 27 November 2001. Equitable explain their thinking behind the different uplift and voting values being given to non-GAR policyholders.

An HMT official seeks advice from HMT’s Director of Financial Regulation and Industry concerning FSA’s recommendation that HMT should approve Equitable’s application for a section 68 Order. He says that ‘FSA were in touch with me this morning to urge us to make a quick decision …’. The official explains:

The concession that has been asked for relates to the rate of interest used to discount future liabilities. Under the Insurance Companies Regulations 1994, this effectively requires the dividend yield to be used. One of the side-effects of this is that a company such as Equitable, which has few free assets, is forced into holding a high level of fixed interest securities because they have a relatively high yield compared to equities. The more assets with high discount rates the company has the quicker it can cover its liabilities, then any surplus income not utilised in discounting can be used to declare reversionary bonuses. This was recognised as a possible distortion to investment behaviour by the Myners review, since it leads to a bias away from equities and towards fixed interest securities which may act against policy holders’ long term interests.

The FSA has been consulting on a revised method of discounting which incorporates an element of earnings yield. This will be introduced at N2. Rule 5.11(5) of the Interim Prudential Sourcebook allows a company’s post-tax profit to be taken into account. Essentially companies will be able to use the average of the dividend and earnings yields where this is higher than the dividend yield itself, subject to a limit of twice the dividend yield.

The FSA argues that the terms of the Section 68 order are consistent with similar orders given to other insurers and allows Equitable Life to take into account now changes which will in any event be available from 1 December. Equitable’s free assets will increase by around £200 million and the amount of any future profits that the society might want to take advantage of under previous Section 68 orders will be reduced. According to the 26 October letter from [Equitable to FSA], it is also one of the actions identified by Equitable Life as being necessary to “provide sufficient margin for a resilience reserve based upon an equity fall of around 10% by value”.

Taken in isolation, the FSA’s recommendation is reasonable and we would normally accept it. However, the circumstances surrounding Equitable Life make this request exceptional. The order could have a direct impact on the company’s ability to meet its required minimum margin and I assume that Ministers will also have to be told that a new Section 68 order has been requested/granted.

Equitable send FSA details of policy values compared to allocated assets, which are as follows:

[entry 3] FSA’s Chairman asks for comments on a statement in which he would disclose the existence of the side letter and of the renegotiation of the reinsurance treaty. The Chairman says that he proposed to make that statement to the Treasury Select Committee when giving evidence on 13 November 2001.

[20:31] The Director of Insurance says that he believed that it would be appropriate to make the statement proposed but suggests informing Equitable of this, in order ‘to put pressure on them to ensure that the documentation is finalised before the [Treasury Select Committee] hearing’.

The following day (at 08:51), FSA’s Chairman agrees that FSA should warn Equitable.

[19:07] The Director of Insurance informs Equitable, who ‘did not protest’.

FSA’s Line Manager E sends officials a risk assessment entitled ‘Appendix B’, which gives a description of risks or problems in relation to Equitable and the statutory objectives of FSA that those risks would impact on. The note states that Equitable’s ‘Impact Rating of Firm’ is ‘A’ (although it did not describe what this rating signified).

Under the heading ‘Description of risk or problem (including likelihood of crystallisation and time horizon)’, the assessment states:

1. Movements (downwards) in long term interest rates.
2. Potential claims for mis-selling of policies on the grounds that GAR risks were not adequately disclosed.
3. Continued volatility in equity markets. This is unpredictable, however equities have stabilised somewhat in recent weeks.
4. Policyholders withdrawing funds from the Society, whether by way of contractual or early terminations, at rates higher than their asset share.

Under the heading ‘Description of potential impact of the risk or problem’, the assessment states:

1. GAR costs will ultimately be determined by the long term interest rates at the time of the retirement of GAR policyholders. The lower interest rates fall, the higher the realistic cost and the reserving requirements.
2. The precise value of claims is not known, although estimates suggest their value to be manageable, particularly if they can in effect be met by a reduction in the policy values of all investors in the with-profits fund, including those claiming. However there is uncertainty.
3. Further equity falls could reduce the value of the Society’s assets, thus impacting on the Society’s solvency position and ability to meet future liabilities. This could result in future uncertainty and policyholders being disadvantaged. The Society’s equity backing ratio is however significantly reduced after managed disposals through 2001 so the risk is now less than it has been historically.
4. Equitable has been paying contractual terminations at the full notional policy value (effectively smoothed asset share) at a time when aggregate policy values are slightly higher than the available assets. Non-contractual terminations are subject to a financial adjuster, which means that they are currently being paid at slightly less than asset share. If payments get out of line with the value of the assets, this has the effect of reducing the value of the investments of those staying in the fund.

Under the heading ‘Which statutory objectives will it impact on?’, the assessment states:

• Maintain confidence in the UK financial system. The financial weakness of a significant participant in the financial system (particularly the oldest Life Assurer in the world) is causing widespread lack of consumer faith and negative publicity. A further deterioration in the position will aggravate matters.
• Secure the appropriate degree of protection for consumers. A further weakening in the financial position of an institution could result in policyholders being disadvantaged.

Under the heading ‘What are you doing about the risk or problem?’, the assessment states:

The FSA are actively liaising with the Society, the policyholders and various action groups to ensure that active communication and dialogue is taking place between the relevant parties. FSA are holding regular meetings with the Society’s board to review its proposed action. In addition, the financial position is being closely monitored, for example by requiring the Society to submit monthly returns.

The FSA is also working closely with the Society on its proposals for a compromise scheme under section 425 of the Companies Act which it is hoped will compromise both the rights of certain policyholders to take an annuity at a guaranteed rate and the potential claims that some policyholders may have if they can demonstrate that the risks of the GAR costs were not adequately disclosed to them and they have a loss as a result. This would remove some of the most significant uncertainties facing the with-profits fund and enable it to be managed more strategically.

Under the final heading ‘What is the desired outcome (including time horizon for mitigating the risk or addressing the problem)?’, the assessment states:

The FSA has made clear that it believes an appropriate compromise along the lines described above will be the best way for the Society to deal with its problems in the interests of all its policyholders. General improvements in market conditions, and steady (or rising) interest rates will also help the Society manage its financial position.

Equitable send FSA an amended copy of the proposed addendum 3 to the reinsurance treaty.

[12:24] Line Manager E circulates the addendum and asks for comments from the Head of Actuarial Support and Scrutinising Actuary F.

FSA’s Line Manager E circulates a note of a conversation he had had the previous day with Equitable, in which he had sought to check the basis on which ‘values would be assessed for voting purposes’ in the compromise scheme. He acknowledges that: ‘Clearly, it is very late in the day for us to be asking for further changes to their approach, but it would be better to raise concerns now rather than wait for the court to throw the scheme out!’.

Line Manager E records that Equitable’s intention was now that:

GARs will have their voting values assessed on the basis of policy value or guaranteed value (whichever is the higher) after the uplift. This will mean that the value of the GARs under the individual contracts will be reflected in the voting value … I discussed this with [Chief Counsel A] before she went away and she agreed that the method they are now using is the right one.

For the purposes of agreeing the GAR uplift, non-GAR votes will be weighted according to the higher of policy value and guaranteed value, ignoring any uplift. This would appear to be justified on the basis that any claims individuals might have are not contractual and therefore outside their relationship with the Society on the basis of which they vote. Instinctively I find that logical, but I wondered if the distinction between the different rights (contractual and rights of action under s.62 or common law) might be artificial … Working on the basis of uplifted values makes no difference because everyone is being uplifted by the same amount.

Line Manager E asks if anyone had any ‘violent objections’ to these current proposals.

FSA’s Director of GCD provides the Director of Insurance with a detailed note of the meeting with Equitable on 02/11/2001 about the compromise scheme and on the follow-up to the issues raised. The Director of GCD says that he understood there to have been ‘a very constructive meeting on 7 November at which a process was agreed for addressing the issues necessary to be able to give Equitable the view it needs on its documentation by 19 November’. The Director of GCD sets out the issues discussed at the meeting as follows.

On ‘Weighted voting’, the Director of GCD explains that Equitable’s proposals ‘would operate on a date basis, so that policies bought after a particular date in 1988 would carry twice the votes in the compromise as policies bought before that date’. He says that FSA had raised four concerns about Equitable’s proposals.

First:

… why if such an arrangement was needed to reflect the view that post-1988 policyholders had a better prospect of a successful claim, there should not be an increase in the uplift, as well as an increase in the number of votes. We also asked whether there should be further break points in 1993, on the basis of the … advice [from Counsel for FSA], and for the most recent purchases, where the claim would arguably be strongest of all.

In response, the Equitable and their advisers said that:

• their systems would accommodate not more than one breakpoint;
• their systems would not accommodate a variation in uplift, only in votes;
• the number of non-GAR policyholders who had bought before 1988 was small, and would not justify reducing their uplift.

Overall, we were not quite convinced, and asked for them to verify these points particularly in light of further discussion.

We asked why it was appropriate to have differential voting rights in that, as we recalled, part of the justification for a flat rate uplift had always been said to be to those who had been policyholders for the longest period would have weaker claims, but for larger amounts. The response on this was that they had calculated that these policyholders would have proportionately the same claim, of 4.5%.

Secondly:

… [FSA] asked whether they were satisfied that operating a differential voting system here, and not in other areas of the scheme, was consistent. They said that they currently thought it was. We should ask them to satisfy themselves thoroughly on this point.

Thirdly:

[FSA] then asked about another point relating to consistency in their approach. It appeared that they were working on the basis, for the purposes of the compromise, that all purchasers after 1988 had a claim. Was this consistent with their approach to valuing the aggregate of their misselling liabilities, if that was based on the … view [of Counsel for FSA]that the disclosure obligation bit only after 1993? They said that they believed that their approach was consistent. They had calculated the overall loss not on the basis that liability started in 1993, but on the basis that it was limited to the transfer of value made when they provisioned fully for the liabilities to GAR policyholders. This caused us to ask what provision had been made in their accounts for those who had purchased after the House of Lords decision. It was not clear that provision had been made for these purchases, either in the accounts, or in the calculation of the amount available for compensation. In response, the Equitable indicated that they thought that it was right to keep these claims in the scheme, but that the amounts involved were likely to be small.

FSA’s Director of GCD asks the Director of Insurance whether FSA were content with this.

Fourthly:

[FSA] then asked for clarification of how the dateline operated for those who purchased a series of single premium policies, or topped up existing policies. We were told that the relevant date for top-ups was the date on which the original policy was purchased. We noted that this helped to justify providing a flat rate uplift, since many of those who purchased pre-1988 would have topped up their policies subsequently, in circumstances where they might be entitled to redress as if they had bought a new policy. But we thought that this argument would be equally valid as a justification for flat rate voting rights. In sum, we thought that it would be important for the Equitable to be able to explain to the Court why it made sense to operate variable voting rights, but a flat rate uplift. But the advice from [Counsel], which we accepted, was that so long as we were happy with the fairness of the uplift, the issue of the voting rights was a matter for the Court.

On the ‘Structure of voting arrangements’, the Director of GCD records:

Their papers indicated that policyholders would have votes in different capacities. There would be one calculation of votes on whether to agree the uplift for the GARs, and another on giving up rights to claim for misselling. Would the effect be that it was possible for a non-GAR to vote in favour for an uplift for misselling, but against an uplift to compensate the GARs? In response, it was said that each policyholder would be asked to vote either for or against the scheme as a whole. However, the value attributed to their votes would depend on the capacity in which the vote was being counted.

This led us to ask whether there would be guidance to policyholders on the exercise of their voting rights. It was confirmed that there would be such guidance. In this context, it was also mentioned by the Equitable that policyholders would be entitled to an uplift in respect of misselling rights only if they were prepared to confirm that they believed that they had been missold. We thought that this might cause people to worry, and in particular, cause trustees to be concerned about their position, and what due diligence they needed to undertake before giving such a confirmation. In discussion, it was thought possible that it was not necessary to require a specific confirmation along these lines.

At this point, we asked about the arrangements for trustees generally. The Equitable indicated that trustees would be able to split their votes according to value. In order to assist them to do this, they would be told the value of the votes they are able to exercise, and the proportion by value of their beneficiaries who were GAR or non-GAR policyholders. No issues were raised on this account.

On ‘Those who had lost GAR rights’, the Director of GCD records:

It was then mentioned by [Counsel] that he was aware of someone who believed that he had been misadvised by the Equitable to transfer from a GAR to a non-GAR policy. This individual was concerned that his rights might be forfeited if the scheme were to go through. If that was indeed the effect, it was a vulnerability of the scheme because someone could appear in court and argue that he should not be asked to give up such rights without any compensation, which would be the effect of the scheme as described.

In response, the Equitable said that anyone in this situation would be able to get the uplift payable to a GAR policyholder on showing that he had given up his GAR rights as a result of misselling by the Equitable. Such an individual would not be treated as a GAR holder for purposes of the vote, because the position would not be established at the time of the vote. But he would be treated as a GAR holder for purposes of the uplift, assuming a successful vote.

We said that it was important that this mechanism should be created by a legally binding means. This could be by incorporation into the scheme itself, or by an undertaking to the Court. But it should be dealt with formally in advance, rather than depending on a policyholder making representations at the Court. It was agreed that this mechanism was only to be provided for those who had been persuaded to give up GAR rights. It was not appropriate for those [who for] example, whose GAR rights had lapsed.

On ‘International policyholders’, Equitable reported that ‘in their view international policyholders had the same rights to claim for misselling as anyone else’. FSA ‘expressed surprise that 1988 should be a key day for them, as well as for UK policyholders, but were told in response that no or virtually no overseas policies had been sold before 1988’.

On ‘Retirements after vote but before implementation’, FSA’s Director of GCD records that there had been:

… a discussion initiated by the Equitable of the position of those who wished to retire after the announcement of the result of the vote. It was suggested that these people would be in a position to exercise their guarantee rights in the knowledge of the outcome of the vote, but before the compromise took effect. The suggestion was that this would be a drain on the resources of the company. In response, colleagues said that we thought that this was a problem only if the policy values were not properly aligned. We also had difficulty in seeing by what authority the company would suspend people’s rights to retire.

FSA’s Director of GCD says that, following on from this, Equitable’s use of a market value adjuster had been discussed and records that:

I said that we had been advised that the MVA was vulnerable to challenge in its present form because of lack of public clarity as to the basis on which it would be exercised. Our understanding of the position was that it would be possible for them to make the MVA robust, if they were to clearly commit to exercising it on limited grounds. The confirmation they had given us so far about the basis on which the MVA would be operated did not achieve this result, because it did not constitute a public commitment which would bind the company. It would be in our view wise for them to consider again making such a public statement.

(Note: this view had been previously expressed by the Director of GCD on 14/03/2001 [16:15].)

FSA’s Line Manager E distributes an amended copy of the note of the meeting with Equitable held on 06/11/2001.

[18:29] The Director of GCD thanks him for the note and says that Legal Adviser E would prepare a summary of the revised reinsurance treaty. The Director of GCD also comments that:

and the Director asks:

Is it publicly understood that the misselling uplift will be even lower if no money from Halifax? What happens if deal delayed so that [Halifax] money not paid – must not end up needing a new vote because this not properly clear.

Further to his request of 08/11/2001 [12:24], Line Manager E seeks actuarial advice from the Head of Actuarial Support and legal advice from Legal Adviser E on the revised terms of the reinsurance treaty. The Line Manager says:

One issue on which Equitable are seeking our views is the provision in article IV that limits the cover available. It is done on the basis that there is a ratchet that means the amount claimed can only ever go down, and the amount available is restricted to the lower of 120% of the reduction of reserves needed because of the Treaty or the amount shown in the schedule.

To the Head of Actuarial Support, he says:

As far as I can see (and I assume the reduction in the reserves means the full amount rather than the amount in excess of £100m), that means there is from the outset a cap of £840m (1.2 x £700m) on the amount that can be claimed, so the amounts shown in the Schedule for the first ten years are meaningless. [Head of Actuarial Support], I would welcome your advice on what we would find acceptable.

To Legal Adviser E, he says:

… I notice that there is provision in Article VI that says in effect the treaty is only valid so long as there is no change in the policy of paying GARs, and that Ireco has the sole discretion in deciding whether there has been a change. I was worried by that – and how it relates to the arbitration provision, if at all. [Legal Adviser E], I would be grateful for your advice on whether, if Ireco were to use some obscure issue to determine that there had been a material change, there is any effective mechanism for Equitable to challenge what otherwise appears to be an absolute discretion of the reinsurer. If there is not, I think we would have to reject that term.

FSA’s Legal Adviser E sends the Director of GCD, the Director of Insurance, Line Manager E and the Head of Actuarial Support a document setting out his understanding of each clause of the addendum to the reinsurance agreement and initial comments on the drafting.

[17:29] The Director of GCD says that Adviser E’s note: ‘indicates that the net effect is formally to limit the amount payable to £100m in the first year. On that basis surely its real effect is not that the side letter will have no effect, but that it will have full effect, so not desirable that they should sign it’.

[17:33] Line Manager E disagrees because: ‘the GAR liabilities will arise over time, not all in the first year. Therefore, if the maximum funding available under the treaty is £1000 million, and that needs to cover a period of at least 30 years, I do not think we would expect more than 10% of the total to be due in any particular year’.

Line Manager E provides officials with a revised brief for FSA’s appearance before the Treasury Select Committee on the line to take on the guidance about reserving for annuity guarantees issued on 18/12/1998. A part of the response includes the statement:

The Equitable Life’s position was that it had significant exposure to GARs, but it was dealing with that exposure by adjusting bonus payments to minimise the impact. It considered that was an appropriate practice and that it was a lawful practice. With the benefit of hindsight, we – and indeed the High Court that endorsed the policy – now know that view to be incorrect. It seemed therefore, at least until the Court of Appeal, and indeed until the House of Lords gave its judgment, that there was no need for the company to consider demutualisation (or any other such strategy) because of the GARs. That said, it was clear the Society was fundamentally weakened and would need to consider its position in the medium term.

It is certainly true that notwithstanding the position in the Courts, Equitable Life was having to set aside significant reserves to comply with the Insurance Company Regulations. By definition, that reduced the surplus assets but it certainly did not eliminate them (the 1999 year end returns show a surplus over the statutory requirements of about £3 billion).

The guidance by the Treasury, which in effect was inherited by the FSA which subsequently withdrew it, was issued to give practical advice to companies about how the cost of GARs should be met and highlighting the potential impact on the reasonable expectations of policyholders. It was not directed at any particular company and was not intended to endorse the approach adopted by any particular company. It was given on the basis of our understanding of the legal position – and clearly we acted immediately [when] we realised our understanding was incomplete. We have no evidence to suggest that the guidance encouraged or discouraged any demutualisations or sales.

FSA’s Director of GCD gives the Head of Actuarial Support, Scrutinising Actuary F, Line Manager E and the Director of Insurance his comments on the maximum benefit which he believed Equitable could claim in their returns for the reinsurance treaty, based on the interpretation he and Legal Adviser E shared as to the revised addendum. The Director of GCD says that the maximum benefit that Equitable could receive on a claim of £1bn would be a loan of £250m, for which Equitable would have to pay back £375m. He adds: ‘Sounds of doubtful benefit to me, though these figures have not benefited from actuarial input’.

[10:02] The Head of Actuarial Support comments: ‘I am not sure how the £250 million is derived, but I think it must depend on the interpretation of the limit in article IV. We have already advised [Equitable’s Finance Director] and [Appointed Actuary] that the wording of this article is dubious and should in our view be amended’.

[10:29] The Director of GCD explains that he had derived the £250m figure from Article IV ‘which allows for up to 10 per cent pa of aggregate of claims outstanding and payments made’. He says that FSA’s Chairman would like the Head of Actuarial Support to pursue with Equitable how their advisers saw the position.

FSA’s Head of Actuarial Support sends Chief Counsel B and Legal Adviser F a copy of his note of their discussion the previous week about the comments on mis-selling liabilities made in Equitable’s letter of 26/10/2001 [09:57].

The Head of Actuarial Support records that they had reached the following conclusions in four areas. First, FSA note that:

Equitable are arguing that a discount needs to be applied to the gross value of the claims for mis-selling to allow for (a) the strength of the various individual claims and (b) the contribution that all policyholders would have to make towards meeting these claims.

The conclusion reached by FSA was that they:

… accept that a discount for (a) is correct in principle. For (b), the effect is also acceptable in principle.

The Head of Actuarial Support states:

The reason for the conclusion in (b) is that arguably they should really have set aside through provision an amount for the gross cost of mis-selling which would have impacted at that stage on policy values – non-GARs would thus have “contributed” to that provision. An uplift would then be offered as a second step for the mis-selling – which would act as a release of the provision for bonuses and the general fund. However, we accept that in practice, it is acceptable to combine these two steps and offer a single net uplift to the non-GAR policyholders with mis-selling claims. This approach is only appropriate for non-GAR policyholders who remain with the Society.

Secondly, FSA note that:

Equitable are offering an uplift (before discounting) on policy values corresponding to the adjustment made in 2000 to policy values to cover the cost of GARs (ie the withholding of any final bonus in respect of the first 7 months of 2000).

The conclusion reached by FSA on this point was:

Since part of the loss sustained by non-GAR policyholders relates to their expected benefits rather than the guaranteed benefits, it seems reasonable that part of the compensation offered should likewise take this form. In addition, though, Equitable suggest that in the absence of the GAR issue, they might have declared a 4% bonus addition to the guaranteed benefits in 2000. Therefore, they are also offering alongside the uplift to the policy value a 4% (or 0.5% for those pre-96 policyholders who have already received the contractual minimum 3.5% increase) to the underlying guaranteed part of their benefits, and this seems appropriate.

Thirdly, FSA note:

Equitable have not specifically answered the question that we asked about the rights of policyholders who leave before the scheme becomes effective (though the latest scheme documents suggest that they do now accept that they would have possible claims).

The conclusion reached by FSA on this point was that they:

… would concur with them that such policyholders are unlikely to be able to claim for recovery of any financial adjuster as such (the question is whether the policyholder received less than the “comparable policy”, but subject to not compensating for market conditions). However, it does seem likely that they could recover the gross value (without discounting) of their GAR-related loss, and they will then need to provide accordingly for mis-selling claims by all those policyholders who leave the Society before the scheme becomes effective. For most pre-16th July leavers, we accept that there may not be any loss to be recovered when measured against an industry comparator, but for subsequent leavers, it is likely that a loss can be identified – though the loss by reference to an industry average comparator is likely to be larger than the direct GAR-related loss, and the latter should therefore be the sum recoverable on a successful claim (all else being equal) to avoid compensating for market conditions.

There is a potential presentational issue arising out of [the issue]. Policyholders ought to be made aware of the nature of what they are giving up and what they are receiving in return. The misselling claims are rights which are subject to proof (their value is also uncertain and in some cases may be zero). In return for giving up those rights the policyholders are asked to take a combination of rights (the reversionary bonuses being “reinstated”) and of hope/expectation (the “uplift” in the policy values). The references to uplifting policy values might be misleading as suggesting that policyholders are swapping one type of right for another.

[21:39] Legal Adviser F gives comments to the Head of Actuarial Support on his note, having discussed the matter with Chief Counsel B.

FSA’s Director of Insurance informs Line Manager E of a conversation he had had with Equitable about: reinsurance; the cover for the required minimum margin; disclosure of the initial hearing date for the compromise scheme; and the financial position set out in Equitable’s Chairman’s letter to policyholders about the compromise scheme. This is copied to Managing Director B, the Director of GCD, the Head of Actuarial Support, the Head of Life Insurance and Legal Adviser E. On the cover for the required minimum margin, the Director of Insurance records:

[Equitable] thought that without more than £100m [reduced reserving from the reinsurance treaty] it would be “very thin at best”.

On the financial position set out in the Chairman’s letter, Equitable had: ‘said that the latest draft … had two paragraphs on this. He would consider what more could be done, but said that there was a limit to what was practical’. The Director suggests that FSA should ask for a copy and discuss this further.

The Director of Insurance also informs the Line Manager of a conversation that he had had with HMT:

… to ask whether HMT had made progress on the s68 order allowing the Society to apply the post N2 valuation rules. [HMT’s Director of Financial Regulation and Insurance] said that it had not. It was pretty clear HMT have no appetite for taking a decision on this. [The Director] said that they would need more information before they could consider it. In particular how many other companies had applied; would the new rules apply to the Equitable “in toto” and would they be compliant with them; was there any interaction with other s68 order extent. He could not say that the application would be processed this afternoon if we could supply this information (it would depend on what else “turned up”). Equally he did not say that they would not deal with it.

[14:47] In response, the Head of Actuarial Support informs recipients of the note of a further concern about the revised reinsurance treaty which he had. This was:

In addition to the points raised by [Legal Adviser E] (and my earlier concerns expressed to Equitable on article IV), I am puzzled by Articles II and XII. This appears to make Equitable liable in the event of cancellation of the agreement to payment in cash of the balance of the Additional Fee and Risk Amount, but the reinsurer does not seem to have any liability in that event to Equitable. I could understand the reinsurer wishing to use this mechanism to recover any cash advanced under Article V, but otherwise, this does look potentially quite onerous.

FSA’s Head of Press Office asks the Director of GCD and the Director of Insurance for comments on what FSA could say about Equitable’s reinsurance treaty and the side letter. [15:18] The Director of GCD provides some comments but says that he believed that most of this would need to come from the Director of Insurance and his team.

[16:40] The Head of Life Insurance provides some of the responses to the Head of Press Office’s questions but explains that they were waiting for further information from Equitable and further analysis on the solvency cover from the Head of Actuarial Support.

HMT’s Director of Financial Regulation and Insurance informs an HMT official that FSA’s Director of Insurance had telephoned him about Equitable’s section 68 Order. The FSA Director had said that the Order would simply mean that Equitable were complying with the new rules to come into effect from 1 December 2001. HMT’s Director says that he had asked FSA how many other insurance companies had been given similar concessions and whether this meant that Equitable were complying with the post-1 December 2001 regime completely or were being given an opportunity to ‘pick and choose’ from the two regimes.

The HMT Director says that FSA’s Director of Insurance had agreed to get back to him as he did not know the answers and comments that: ‘The subtext here seems to be [FSA’s Chairman’s] appearance tomorrow before the [Treasury Select Committee], & further doubts about the reinsurance agreement which (in the absence of the s68 order) could/might mean [Equitable] are below their regulatory solvency margin, at least under the old rules’.

FSA’s Scrutinising Actuary F lists for the Head of Actuarial Support some of the possible problems with the reinsurance treaty which had been identified so far. The Scrutinising Actuary points out that his review was not complete and says that he was providing the comments so that Line Manager E could give some preliminary feedback to Equitable that afternoon. The list of possible problems includes:

• There appear to be 2 caps which limit the overall potential exposure of the reinsurer. One is a “Limit of Cover” schedule which decreases from year to year, starting at £1,000m. for calendar year 2001. The other is that the limit in any year will not exceed 120% of the reassurance offset which applied in the previous year. It seems to me that the treaty therefore provides very limited protection against falling long term gilt yields, and that [Equitable] remain exposed to the risk of a further sustained increase in GAO costs. I therefore question what allowance [Equitable] can make in their Returns for this sort of arrangement.
• Article 4 refers to the Reinsurer being liable for any Reinsurance Claims Amount as at 31 December each year. Is it not liable at any other time during the year? [Equitable] needs continuous protection, and needs to meet solvency requirements throughout the year. What is the Reinsurer’s liability during the year if at that point the GAR take-up rate over the year to date has been less than 60%, but the Actuary would set a valuation assumption well in excess of 60%?
• In Appendix 1, there are conflicting definitions of the “Reinsurer’s Liability”. Under the subheading “Reinsurance Claim”, the first and last sentences give different definitions.
• Also in Appendix 1, I do not understand what the re-definition of “Current Annuity Rate” (when the £100m. threshold is passed) is seeking to achieve. It refers to a 15 year gilt yield – at what date? What is the impact of this clause on the reserves held in the resilience test?
• l Also in Appendix 1, the “Claims Recovery Premium” is defined. This is due for simultaneous payment by the Reinsured to the Reinsurer should a Reinsurance Claim event occur. In this case, shouldn’t [Equitable] reduce the reinsurance offset on Form 52 by the amount of the Claims Recovery Premium? This could depress the Reinsurer’s overall limit and potentially lead to the collapse of the treaty?        
• What is the rationale for [Equitable] agreeing to purchase £40m of hedging instruments should the compromise scheme fail?
• [Legal Adviser E] has identified, in his earlier note, several areas where the “Termination” Clauses may be unsatisfactory, as well as many other points which need to be worked through.

  Scrutinising Actuary F concludes that his: ‘overall reaction is that this arrangement is little more than “window dressing” and the reinsurer has no intention of assuming any serious risk at all’.

  [15:42] The Head of Actuarial Support replies:

  In reply to your first indent, we would expect to see [Equitable] make provision for a reduction in interest rates to the regulation 69(9) level with possibly a further fall in the resilience test, so that along with the 120% ratio, there would be some modest protection against further falls in interest rates.

  I think the Claims Recovery Premium is designed so that in the event of no final bonus being paid, as is likely to occur if the compromise is rejected, the full cost of the GAR would be included in the reinsurer’s liability.

FSA’s Director of GCD informs officials of a telephone conversation with Equitable’s solicitors about his concern that the only value from the reinsurance treaty should be the cash payment available. The Director of GCD says:

They indicated, and I agree, that the agreement provides for benefit over and above the cash payments, in the sense that it creates an entry to the credit of the reinsured in the books of the reinsurer. This never becomes payable to the insured. On liquidation of the insured, for example, it is automatically extinguished. But if this is sufficient to create an actuarial benefit, it is there.

The following day [at 08:35], the Director of Insurance thanks him for the ‘helpful’ comments. The Director of Insurance sets out his understanding of the reinsurance treaty, saying that:

… the revisions to the Treaty now proposed would reduce the effect of the various limitations in the version we saw last week. While the annual cash limit remains the overall benefit of the asset held by the reinsurer on the reinsured’s account (net of the various payments that would have to be reserved for) [that] would be of significant benefit to the reinsured. It would, in this respect, be consistent with the original treaty (absent the side letter) which we accepted for reserving purposes at the time. The main difference, if the amendments are accepted, is that it sets out in definite terms how the treaty operates above the £100m level and what payments from the reinsured have to be made in those circumstances.

FSA’s Head of Actuarial Support thanks Legal Adviser F for his comments of 12/11/2001 [21:39]. The Head of Actuarial Support points out, however, that: ‘There is no requirement for companies to make any provision for final bonuses. Therefore, I am not quite sure if we are saying that they should though have made a provision for the gross mis-selling claims, but then allowed this to be reduced because a significant part of the compensation is being added as an increase in their discretionary (ie non-guaranteed …) bonuses rather than as an increase to their guaranteed benefits’.

Legal Adviser F replies that he thought he had: ‘meant that they would have provisioned for the whole (gross) misselling liability which inevitably impacted on the ability to pay final bonuses across the board. That provision would be released by compromising the misselling claims – again across the board. They are reinstating what they would have done – ie declaring reversionary bonuses, which takes up some of what is released, leaving the rest in the “pot”, which impacts on the “policy value”’.

The Head of Actuarial Support asks:

Does that then mean that they would have to provide for the full gross mis-selling costs if the compromise were not to succeed?

The Legal Adviser replies: ‘I suspect yes’, although adding that ‘the discounts for probability of success could still be applied’. Legal Adviser F states that:

This is only a reflection of the comments I made when we met that (with the benefit of hindsight) one might reasonably have expected the Society to have done this for some time now.

The Legal Adviser adds, however, that: ‘I’m afraid I don’t know enough about life company accounting to know whether they could achieve the same result differently. (But in favour of that approach is that the impact of the provisioning must be that leavers also “pay” for a share of their misselling claim – which is part of my rationale for agreeing that the effect is appropriate in the scheme.)’.

[12:46] The Head of Actuarial Support sends Line Manager E a copy of his note on the conclusions that had been reached about the comments on mis-selling liabilities made in Equitable’s letter of 26/10/2001 [09:57]. (See 12/11/2001 [09:57].) The Head of Actuarial Support also send him the record of his discussions with Legal Adviser F of that morning. He also sends copies of all of this correspondence to the Head of Life Insurance, Scrutinising Actuary F, the Director of Insurance, Chief Counsel A and Legal Adviser F.

The Head of Actuarial Support explains:

This is where we have now reached here on the subject of the provisioning for mis-selling claims and hence the reasonableness of the compensation offer being made as part of the compromise scheme. I think this means that we would expect to see a rather larger provision of closer to £500 million (as opposed to their suggested figure of £300 million) for mis-selling claims.

However, we would not object in principle to their proposed offer of compensation for giving up their “GAR-related rights” in the compromise being discounted for both the probability of success of the claims and also the payment by all policyholders of a proportionate share of the cost of this compensation so that an average uplift of 25% of policy value (including the Halifax money) would seem to be defensible.

Equitable’s solicitors send FSA some amended text concerning the reinsurance agreement.

The following day [at 17:29], the Director of GCD circulates the text, saying that it aimed to meet the points made by the Head of Actuarial Support.

The Head of Life Insurance sends FSA’s Chairman a paper on ‘What view FSA should take on the Compromise Scheme and how and when that view should be promulgated’.

The paper sets out the ‘Background’, including ‘Recent Developments’ and the latest ‘Scheme Timetable’, the latter being:

The Head of Life Insurance says that the decisions FSA needed to make were:

1. By 21 November, two related decisions are needed:
   1. We need to be able to indicate to the Equitable Board whether we see any “Show Stoppers” or whether there are any aspects of the Scheme which we might need to criticise publicly.
   2. As a condition of Halifax’s approval of the Scheme, Halifax want confirmation that the FSA has no objection to the proposed Scheme or to the draft Scheme documents being issued to those entitled to vote. A form of words is needed for inclusion in the Scheme documents. This will be needed in time for the 21 November Board Meeting.
2. The FSA could be represented at the convening hearing, either to make a statement, or to be ready to respond to any questions the court may have.
3. We are publicly committed to making our views known to policyholders before they vote. Although the voting meetings will not be held until January, voting papers will go out from the beginning of December and we believe we need to be ready with our statement at the beginning of this period.
4. FSA may wish to be represented at the substantive court hearing in February 2002, and submit a witness statement. The substance of any such statement would have to be the same as in any statement to policyholders before the vote, but the argumentation may need to be fuller.

FSA’s Head of Life Insurance explains that FSA had been in regular contact with Equitable over the development of the scheme and that the latest version took account of most of their concerns and questions. He says that ‘Equitable have explained that some of our suggestions cannot be met fully (eg there are constraints on their ability to provide updated financial information)’.

Under ‘Assessment’, the Head of Life Insurance says that FSA were still reviewing the scheme documentation as it was received from Equitable and that this ‘is not yet final, but on the basis of the drafts seen to date, we have assessed the proposals under two broad headings’, these being the fairness of the scheme and the clarity and accuracy of its communication.

Under ‘Fairness’, the Head of Life Insurance writes:

Policyholders are divided into three classes for voting purposes. The classes are primarily a matter for the court to adjudicate and are not strictly an issue for the FSA. But we have reviewed the reasoning behind the creation of three classes and see no reason to object to it.

We set out the criteria against which we would assess any Scheme in a letter to the Equitable of 3 September 2001 … using these criteria as a basis, we have considered whether what policyholders are being offered is a fair exchange for what they are being asked to give up, and whether within each group of policyholders, the distribution of sacrifice and reward is broadly fair.

For GAR policyholders, the Head of Life Insurance says that FSA:

… believe that the uplift, which they are being offered, is a fair exchange for giving up their rights to GARs. We also believe that the variation in uplift is a fair reflection of the differences in value of different GAR policies. We had some concerns that those close to retirement were not receiving a sufficient uplift to reflect the value of their GARs; but we believe that the latest uplift figures, combined with the other less tangible benefits flowing from the Scheme (such as greater flexibility in the types of annuity available) mean that this group are being treated fairly.

For non-GAR policyholders, FSA’s Head of Life Insurance writes:

Following representations by [lawyers appointed to act] on behalf of the non-GAR policyholders, non-GARs will be divided into two voting classes:

• In respect of the uplifts offered to GAR policyholders; and
• In respect of the uplifts offered to non-GAR policyholders in return for giving up any mis-selling claims they may have.

As regards the proposals for non-GAR policy uplifts we applied the same analysis as for the GARs. We believe that the 2.5% uplift offered represents a fair exchange for the surrender for any GAR related mis-selling claims; taking into account the uncertainty involved and the fact that non-GAR policies represent 75% of the with-profits fund, so that effectively they must meet 75% of their own compensation. The flat distribution of the uplift is more difficult: it can be argued that the strength, nature and hence quantum of claims varies according to the date and circumstances of the sale. However, there are two arguments for accepting a flat uplift. First, and most powerful, is that the costs of constructing a more refined mechanism for uplift (in terms of resource devoted to detailed research, delay and consequent loss of the Halifax money) was so great that policyholders would lose more than they gained. Secondly, the most significant difference is the strength of claims as between pre 1988 and post 1988 policies (which became subject to the FS Act & LAUTRO rules): and this is recognised by giving different voting weights to pre and post-1988 policies.

FSA’s Head of Life Insurance says that FSA had considered the position of policyholders who had already left or who left before the scheme became effective and had mis-selling claims, noting that their rights to pursue any claim were unaffected by the scheme. He also explains that FSA had:

… discussed with Equitable the financial implications of claims for mis-selling by policyholders who have left the fund, and the possibility that awards by the court or the Ombudsman could be higher than the 2.5% uplift provided for in the Scheme. Equitable explicitly disclose in the Interim Report that should each policyholder (instead of accepting the Scheme) choose to pursue a claim and succeed in claiming compensation, then the costs of the Society could be substantially higher than the aggregate £850 million which they have estimated as a starting point (before discounting) for calculating uplifts in the Scheme. However, Equitable have confirmed that they consider that the aggregate cost of claims by policyholders who have left the fund or who may leave before the Scheme becomes effective, would not be material, and they have made no provision for these claims.  

The Head of Life Insurance also explains that FSA had:

… considered with the Equitable whether the fund could withstand large scale departures after the conclusion of a successful Compromise Scheme. At present, policy values are sufficiently close to asset shares to mean that the fund is not currently being damaged by departures (payouts on maturity are approximately 102% of asset shares and policies on surrender approximately 92% of asset share; the average of all payouts is about 98% of asset share). However, in the event of large scale departures final bonus rates may need to be cut across the board.

Lastly, FSA’s Head of Life Insurance states that FSA had considered whether the scope of the rights being compromised was fair and clear, which FSA believed was the case.

Under the heading ‘Communications’, the Head of Life Insurance sets out FSA’s assessment of ‘the overall clarity and intelligibility’ of the scheme documentation. He says that the documentation was thorough and comprised:

• letter from Equitable’s Chairman to policyholders;
• The Scheme Document’;
• question and answer material, including frequently asked questions and directions to where more detailed information could be found within ‘The Scheme Document’;
• Equitable’s ‘Interim Report for the Half Year ended 30 June 2001’;
• a report by Equitable’s Appointed Actuary; and
• a report by the Independent Actuary.

The Head of Life Insurance continues:

Our basic approach has been that the Equitable’s material should be sufficient to give policyholders a clear and balanced picture, and that the FSA should not need to put out any supplementary statement of its own to achieve that clarity and balance. Specific issues which we have discussed with Equitable are:

1. Adjustments to the summary of the Scheme, to present a fair and balanced summary.
2. Presentation of the financial position. We are concerned that policyholders should have enough financial information to be able to make an informed decision when they vote. There is an Interim Director’s Report for six months to 30 June 2001, which stresses the fundamental circumstances. In addition the Scheme document will contain a proforma balance sheet (based on 30 June 2001 figures) which will show in broad terms the effect of the Scheme on these figures: and the Chairman’s letter contains additional financial information (size of fund, value of surrenders, proportion of the fund invested in equities) as at the end of September 2001. We discussed with Equitable whether a balance sheet as at 30 September could be produced. However, their view is that the Directors have an obligation to verify any information included in the Scheme documents, and they would want the auditors to review it. This could not be done in the time available before the launch of the Scheme. This issue remains under discussion.

We have been particularly concerned that the policy values quoted to policyholders in connection with the Scheme should not give a misleading impression (for example, if aggregate policy values were significantly higher than asset shares, there must be a serious prospect of a future cut in policy values (by way of a reduction in final bonus); and policyholders would need to understand this when they voted on the Scheme).

The Head of Life Insurance sets out a fuller analysis of these issues in an annex to the paper. This analysis is largely the same as that produced as a result of the meeting held on 14/08/2001.

The Head of Life Insurance then turns to ‘Contingency Planning’ saying that, should the scheme fail for any reason, FSA:

… would need to monitor the ongoing financial position even more closely than at present. We would also need to decide how to deal with claims for mis-selling by non-GAR policyholders in the absence of a Compromise Scheme. Rather than leave individual policyholders to seek redress through the courts or through the Ombudsman, we envisage requiring the Equitable to set up a process for review and redress, in consultation with [the Financial Ombudsman Service].

We are also reviewing the options for Equitable if the Scheme were to fail (the immediate fallback is to soldier on, but this will need to be kept under review against the possible alternatives (eg administration or provisional liquidation).

He lists the ‘Outstanding Points’ for FSA as:

• We need to take a view on whether to press (or require) Equitable to publish more financial information as at 30 September, despite their arguments against this.
• The Reinsurance Treaty has been renegotiated, but is not yet signed. We have been asked to provide a “comfort letter” to IRECO that we do not object to the revised terms.
• Equitable are resisting our request that they make known publicly the date of the Convening Hearing.
• Our assessment has been made on the basis of rapidly changing draft texts. We are still reviewing the latest draft (received today), but we have taken account of the significant changes.

Finally, the Head of Life Insurance gives the ‘Issues for decision, and recommendations’ as:

1. Statement of FSA’s view on the Scheme documentation

Subject to resolution of the outstanding points listed above, I recommend a short and low key form of words, [such] as

“FSA has been kept informed as the Scheme has developed. FSA has powers to intervene to object if it believes that the Society is acting without due regard to the interests of policyholders. It sees no need to exercise these powers, and considers that the proposed Scheme is a reasonable one for the Society to put to policyholders to vote on.”

2. Representations at the convening hearing on 26 November

I recommend that FSA should not be represented. There is nothing further we need to say: and Counsel has advised that the judge in this case would be likely not to welcome any representations from the regulator.

3. Statement of FSA’s views before policyholders Vote

I recommend that this should draw on the analysis given above, and should be put out in the form of a statement to the press and on the FSA website. (An alternative would be to seek to put an information sheet in the material which the Equitable themselves put out; but this would have the presentations disadvantage of appearing to link the FSA too closely with the Equitable’s Scheme. There would also be severe practical difficulties over timing.) If you agree with the approach we will submit a draft for approval by the end of November.

FSA’s Director of Insurance writes to the Head of Life Insurance, Line Manager E and the Head of Actuarial Support about Equitable’s solvency margin, ahead of a meeting with FSA’s Chairman the following day to discuss FSA’s views on the compromise scheme. The Director of Insurance notes that the Chairman was also due to meet Equitable to discuss FSA’s outstanding concerns on both the reinsurance treaty and the compromise scheme.

The Director says that, against this background: ‘[Managing Director B] feels that we must be able to give [FSA’s Chairman] definitive advice on the Society’s solvency position with which we are all content. He recognises that this is [inevitably] a matter of uncertainty and judgement rather than demonstrable fact, but feels, quite responsibly, that we must have a united position on which we would, if necessary stand publicly’.

The Director suggests ‘something like’:

The Society’s financial position is subject to considerable uncertainty. It depends critically on assumptions about:

• the amount which should be reserved for misselling claims, only some of which would be resolved through the compromise scheme
• outflows of cash (and liabilities) since the most recent figures provided to us
• the reliance which may reasonably be placed (beyond the £100m initial limit), on the Ireco Treaty.

We understand that the view of the Society’s appointed actuary is that the Society’s position is likely to be “just the right side of the line”. There is some justification for this. In particular advice provided to the Society and (separately) to us is that there are arguments for believing that the “letter of understanding” may not be relied on by the reinsurer to avoid liability under the treaty above the £100m initial limit. The Appointed Actuary also believes, based on his work on comparative performance of Equitable and “industry average” products, that the quantum of misselling claims that would not be settled through the compromise is likely to be relatively small.

In our view, this assessment does not apply the degree of prudence which, consistent with the regulations, we would expect. In particular we think it would be imprudent (notwithstanding the legal advice) to make any allowance for reinsurance above the £100m initial limit. We also believe that more allowance should be made for misselling claims than the Appointed Actuary does. On this basis we believe that a prudent assessment of the Society’s financial position would indicate that, while its assets continue to exceed its liabilities (subject to the fundamental uncertainty to which we and the Society have consistently drawn attention), the Society currently fails to meet its required margin of solvency by some £xxxxx. We note however that the position will be improved by some £yyyy on 1 December 2001, when new valuation rules come into force, or earlier if HMT make an order under s68, in response to an application which the Society has made (and which we have recommended should be granted) allowing the Society to value its liabilities in accordance with the new rules.

The Director of Insurance seeks comments on this and asks the Head of Actuarial Support to provide the missing figures.

FSA’s Head of Life Insurance asks the Head of Actuarial Support and the Director of GCD whether they were content with the revised reinsurance treaty received from Equitable the previous day.

[10:01] The Director of GCD says that it was necessary to meet the Head of Actuarial Support’s concerns and so it was for him to comment, unless he needed advice.

[10:16] The Head of Actuarial Support does not say whether or not he is content but outlines an outstanding concern. This is:

The wording of the agreement, including Article IV is still very convoluted, so there must be some legal risk of potential dispute over its interpretation. However, my understanding continues to be that the Equitable could claim an amount of cash each year equal to 10% of the cumulative Reinsurance Claims Amount, as calculated under Appendix I (ignoring any earlier cash payments), subject to the overall limit in article IV. This aggregate limit would then apply to the sum of the Reinsurance Claims Amount (whether withheld by the reinsurer or advanced in cash) and the amount described at paragraph (1) of Article IV.

If so, then I think this would allow a reasonable value to be placed on this reinsurance agreement as I indicated earlier. I note though that the reinsurer does seem to have considerable discretion in Article VI to determine whether Equitable has altered its practice in relation to GAOs.

FSA’s Director of Insurance sends FSA’s Chairman a draft letter for him to consider sending to the Economic Secretary to the Treasury about Equitable’s application for a section 68 Order.

The Director highlights three points to note, which were:

• the draft indicates that we believe the Society to be £200m below its margin requirement. This is [the Head of Actuarial Support’s] latest estimate this morning. He is doing further work so that we may give you a definitive view at our meeting tomorrow. It does not include allowance for the s68 order concession or for the reinsurance treaty beyond the £100m initial limit.
• the effect of the s68 order, if granted, would just about restore the Society’s margin. (It follows that this will happen at N2 anyway, subject to any developments between now and then).
• we received last night further documentation from the Society on the renegotiated reinsurance treaty which they tell us is what the Reinsurer believes to be the “final wording”. After review by [the Head of Actuarial Support] and [the Director of GCD] we have now told them that … we have no further objection to it …

[14:02] FSA’s Chairman writes to the Economic Secretary to the Treasury along the lines suggested. The Chairman’s letter reads:

As you will be aware Equitable Life expect shortly to present their formal proposal for a compromise agreement between the Society and its members. The vote on the scheme is expected to be in early January with a court hearing in February. If the scheme is in place by 1 March 2002 Halifax will put in an additional £250m by “forgiving” repayment of £250m already put in by way of loan.

Meanwhile the Society’s financial position is very tight. Information which has recently come to light about a “letter of understanding” sent by their previous appointed actuary to their reinsurers, Ireco, makes it imprudent in our view, for the Society to rely on their reinsurance Treaty to the extent they have done previously. The Society are seeking to resolve their position with … Ireco’s parent [company], but the matter is not yet settled. Meanwhile the effect on their regulatory reserving position is, in our view, to reduce their admissible assets by some £500m.

This problem, together with the effect of various market movements, and the need to reserve for potential mis-selling claims following delivery of the Opinions of [Counsel for Equitable and Counsel for FSA], result, on our assessment, that the Society could be in breach of its solvency margin requirement by some £200m.

This position would be ameliorated, at least in part, if the Society were able to value its liabilities under the rules which will apply from 1 December, rather than under current rules. The Society have applied for a concession under s68 to allow this. You will recall that, with HMT agreement, the FSA announced in September that it would support such applications. The Society’s application was passed to your Department on 1 November, with advice from this Authority, which I had personally endorsed, that it be granted. I understand that your officials have asked my staff for various supporting information which they have supplied.

While it is, of course, for your Department to determine whether the application should be granted, it seems to me that it would be unfortunate if a decision was delayed. May I ask therefore that a decision be taken on this as soon as is reasonably possible.

Equitable also send FSA a draft ‘comfort letter’, which IRECO had requested that FSA should send.

[14:26] FSA’s Head of Life Insurance seeks confirmation from the Director of GCD that he was content for FSA to indicate that they have no objections to the reinsurance treaty.

[17:55] The Director of GCD says that he had no objections.

FSA write to IRECO to confirm that they did not object to Equitable entering into the renegotiated reinsurance treaty.

The notes to the assessment were:

1. Estimated Position at 30 September comes from Society’s last reported full monthly figures.
2. Reinsurance credit is reduced from £650 million to £100 million on the FSA estimate to reflect uncertainties over the application of side-letter, but on the Equitable estimate, this is reduced to around £600 million on the assumption that the renegotiation of the agreement is completed shortly.
3. Adjustment is made by Equitable for an FSA rule change from N2 on the assumed equity yields that may be taken into account in valuing the liabilities. The FSA figures do not allow for this as we have not yet reached N2 and Equitable have not yet received a concession to allow this item in advance of N2.
4. Future Profits item is reduced as a result of (a) anticipation of higher equity yields and (b) the lower yields on fixed-interest securities.
5. An increase in the mis-selling provision (mainly in respect of the notional £10 million set aside for leavers), from £275 million to £375 million is assumed by Equitable. The FSA estimate includes a further £100 million as a result of the fundamental uncertainties involved.
6. Allowance is made approximately for the effect on both assets and liabilities of the reduction of around 0.5% in yields on fixed-interest securities.
7. Equitable also allow for a substantial reduction in the liabilities as a result of switching £1 billion from equities to fixed-interest securities.
8. The combined effect of items (6) and (7) above is believed by Equitable to be around £750 million. We are not entirely convinced by this figure given that the assumed yields on equities and fixed-interest securities are now much closer so that the effect of (7) should be fairly low, but have allowed this adjustment for the present.

Line Manager E asks the Head of Actuarial Support for ‘a paragraph’ on the quantification of mis-selling liabilities.

[16:06] The Head of Actuarial Support provides the following:

For the principal part of their business which comprises pension policies, published survey data indicates that Equitable’s performance relative to the market has been gradually declining over the last 10 years.

For regular premium policies, the payouts have declined from around 110% of industry average in 1990 to 98% in 2000 and 78% in August this year. For single premium policies, the position has declined from around 115% of industry average in 1990 to 98% in 1999 and 93% in 2000 and 71% in August this year. (The figures for August 2001 come from our own unpublished survey and include estimates for the Equitable policies.)

A report was also commissioned by Equitable from [the Appointed Actuary’s company] into their recent payouts. This report suggests that for policies becoming claims before

16 July, the Equitable payouts were likely to have been close to the market average for regular premium policies (slightly higher for shorter terms but slightly lower for longer terms) and around 5 to 12% lower for single premium policies than the market average. This is in line with the above findings from market surveys.

In addition, the [company’s] report suggests that the Equitable payouts since 16 July this year for policies with terms of up to 15 years are between 4 and 13% lower for regular premium policies, and between 13 and 21% lower for single premium policies than the market average. They therefore conclude that payouts on all policies (which they would regard for this purpose as being a blend between single and regular premium) would be at least 5% lower than the market average. This is slightly more flattering than our figures since it assumes that most insurers will be reducing their payouts by a further 5-10% to reflect recent investment market movements.

It may be noted though that none of the above figures make any allowance for the flexibility of these Equitable contracts on retirement, though Equitable have always claimed to be offering this flexibility at no additional cost to policyholders.

In practice, Equitable propose to offer an uplift of 2.5% to policy values. This appears to be rationalised by them roughly as follows:

If all non-GAR policyholders were able to sustain a claim for compensation to the level required to bring their payouts up to the present industry average, then this could result in a total provision of as much as £3 billion being required. This would clearly then have to be offset by a significant reduction in the policy values attributed to all policyholders. The net effect could be that non-GAR policies were offered an uplift of around 6-7% of their policy values and GAR policies a similar amount of uplift to replace their GAR benefits.

FSA’s Insolvency Practitioner provides comments on Equitable’s draft interim report and accounts (see 14/11/2001 [16:01). Those comments include:

• that the fund for future appropriations was £1,114m, rather than £1,511m reported to the FSA in the Society’s monthly reporting;
• whether it was true that no actuarial valuation had been carried out since 31 December 2000;
• that there was an important disclosure in the notes that: ‘Should each policyholder choose to pursue a [misselling] claim and succeed in claiming compensation, then the sums payable by the Society, including associated legal costs could be substantially higher than this amount [£850m].’;
• that no provision had been made for mis-selling claims of former policyholders; and
• that no mention had been made of the problems with the reinsurance treaty, but ‘the auditor’s conclusion is draft pending resolution of the issue’.

[18:08] Scrutinising Actuary F adds:

The main thing to strike me was the repeated reference throughout the Report to fundamental uncertainties (essentially on GAR liabilities, non-GAR mis-selling claims and other potential mis-selling costs), the possible resulting understatement of technical provisions and therefore overstatement of the fund for future appropriations (effectively the “free assets” in Companies Act Accounts terminology), and the differing legal opinions on Article 4, which were also explained … No reader of the Accounts could be left in any doubt as to the seriousness of these issues.

The Scrutinising Actuary also comments on some of the points made by the Insolvency Practitioner:

The fund for future appropriations has declined further, and significantly so, over the 3rd Quarter 2001. Presumably the difference between the figures at 30.06 (£1,511m. as previously advised, and £1,114m. in the Accounts) is due to the greater rigour which would have been applied to determining the figures in the Accounts. It is difficult to say what it is now, but we understand the Society believed it to be of the order of £300m. at 30.09 …

… It is conceivable that no further “full” actuarial valuation will have been carried out since last [December]. The reduction in policy values is likely to have been driven by a comparison of “aggregate asset shares” with the total value of assets. These “aggregate asset shares” are likely to be modelled and tracked on internal spreadsheets (with an element of approximation), whereas a “full” valuation involves downloading data on a policy-by-policy basis from the policy administration systems, and valuing each policy individually.

… The reduction in GAR liability from £1,668m. (at 31.12.00) to £1,454m. (30.06.01) will reflect retirements/surrenders over the period. Had gilt yields remained stable over the 3rd Quarter, the figure would no doubt have been lower still at 30.09. Unfortunately for the Society, recent falling gilt yields will have led to an increase in the GAR liability, but we understand that the Society now believe it is too late for them to rework the figures underlying the compromise scheme.

He concludes that there were ‘some helpful numbers in these Accounts. Apart from anything else, they serve to reinforce the dire situation the Society is in’.

Equitable write to FSA to explain their understanding of the effect of the reinsurance treaty (see 15/11/2001 [13:33]). In relation to the credit they believed could be taken for it in the returns, Equitable say that they estimated that ‘if this draft Addendum 3 had applied on 31 October 2001, the Society’s reassurance reserves for the Business Covered would have been about £600m after a reduction in those reserves of about £100m for future Deposit Premiums, the Additional Premium, and the Additional Fee as described … above’.

Equitable ask for confirmation that FSA agreed with this interpretation of the draft addendum and the effect that it would have on Equitable’s reserves.

An FSA official circulates a revised version of FSA’s information sheet on Equitable which had been substantially overhauled by the Plain Language Commission. She seeks comments by 10:00 on 19 November 2001.

[15:41] The Head of Life Insurance says that one paragraph would need to be amended but this could only be done on 19 November 2001, after FSA had decided their substantive position on the compromise scheme.

FSA’s Director of GCD writes to Legal Adviser F and Legal Adviser E (copied to Line Manager E and Chief Counsel A), following a meeting that morning where FSA’s Chairman had indicated that, in relation to the compromise scheme, he thought FSA’s website should include material on:

• compensation issues, which I understand to include the impact of the compromise on the scope for claiming compensation under the [Financial Services Compensation Scheme] and the way in which the [Financial Services Compensation Scheme] would work in the absence of a compromise: this will need to include a treatment of the position under the Equitable’s Article 4;
• the impact of the scheme on the scope for claiming redress from third parties: for example, would the amount that could be claimed from the government in relation to any maladministration be affected by the compromise, either in a claim by the company, or by the policyholder.

The Director of GCD asks them to ensure that the legal issues are considered.

FSA’s Head of Actuarial Support drafts a letter to Equitable in response to theirs of 16/11/2001, to be sent out under his name by Scrutinising Actuary F.

Equitable reply to FSA’s letter of 08/11/2001 about the implications of the side letter. Equitable say that, now the uncertainty over the status of the reinsurance treaty had been resolved, their attention had turned to investigating the circumstance in which the side letter had been conceived and issued. Equitable say that the preliminary and unaided response from the two actuaries involved to the question: ‘“Why did you not disclose the side letter to anyone else?” has been to the effect that, since it was not legally binding, it did not form part of the agreement about the Treaty and therefore did not require disclosure’.

On 22 November 2001, the Director of Insurance comments to FSA’s Head of Regulatory Enforcement Department: ‘This doesn’t take us very far. Could we discuss next steps please’.

19/11/2001 [entry 2] FSA meet Equitable at FSA’s request to discuss outstanding issues on the compromise scheme. The discussion largely follows the issues set out in the Head of Life Insurance’s letter of 16/11/2001 [18:11].

Non-GAR uplifts and voting rights

FSA note that the drafting changes to deal with their concerns had been agreed. Equitable say that their approach had been driven largely by commercial and practical considerations. However, they had been advised that: ‘the reality was that a more scientific approach to valuing mis-selling claims would not be possible until there had been a reasonable number of test cases to establish some precedents’.

Financial information

FSA repeat their view that Equitable needed to disclose information relevant to the compromise scheme. Equitable say that they believed that information about the current value of the with-profits fund would be of little use to policyholders. FSA point out that their criteria for evaluating the scheme ‘referred to fairness and an important part of that was that policyholders should have the information they needed to be able to form a judgement’. Equitable’s Chairman says that he was sympathetic to the point FSA were making, ‘felt sure the Society could do better’, and agreed to take the matter up with the Society’s advisers.

GAR costs

FSA raise concerns about the calculations for compensating GAR policyholders, as the position had changed since June, when the ‘best estimate’ of the cost of annuity guarantees had been made. FSA’s Director of GCD: ‘invited the Society to consider whether it would be possible to include in the scheme some provision that would require the directors to certify to the Court that there had been no material change to the financial position at the time of the sanction hearing. [Equitable] agreed to consider it but thought it would be problematic (and they subsequently confirmed that they could not do this)’.

Scope of claims being compromised

FSA raise concerns about the treatment of cases where GAR policyholders had been wrongly advised to transfer to non-GAR policies as these seemed to be different from the generic mis-selling claims. FSA say that they believed that such cases should not be caught by the compromise scheme. Equitable say that it would be difficult to ‘carve those claims out’ but agreed that, if the wording of the scheme could not be clarified, they would give an undertaking to the court and ensure that the position was made clear to policyholders.

Court hearing

Equitable’s Chief Executive undertakes to provide FSA with a copy of his witness statement to the court.

IRECO

Equitable say that the revised terms of the reinsurance agreement had been agreed by the boards of Equitable and IRECO’s parent company and would be considered by IRECO that morning. FSA express their concern that the position should be clearly explained to avoid potential misunderstandings.

Other

Managing Director B notes that both FSA and Equitable had been ‘focusing very much on getting things in place so that the scheme could be issued’. It is agreed that some contingency planning should be done concerning a scenario where the scheme did not go ahead.

FSA write to Equitable, following their meeting earlier that day, to give Equitable their view on what the Society needed to do if the FSA were not to object to the compromise scheme. The actions required included:

• the inclusion of additional information about Equitable’s financial position to ‘enable policyholders to judge both the fairness of the offer made for their rights, and what the Society’s financial position might be if the Scheme does not go through’. FSA envisage two elements to this. First, a statement from Equitable that they were satisfied that changes to their financial position and the economic environment did not affect the fairness of the offer made based on information as at 30 June. Secondly, a statement that their overall financial position ‘remains adequately reflected by the 30 June figures; or if this is not the case, indicating significant respects in which it is different’.
• under ‘Scope of Claims Being Compromised’, FSA state:
  • We discussed the treatment under the Scheme of those who had been mis-sold out of their GAR rights into a non-GAR policy. You said that you wanted to “carve them out” of the Scheme. We believe that the Scheme as currently drafted does compromise their rights; and that in order to achieve your objective, it is necessary either to change the Scheme, or to put in place a parallel binding undertaking to the court, under which they will be able to claim redress for any such mis-selling on the same basis as if the Scheme had not become effective.FSA say that they were happy with this approach, so long as: this was a small number of policyholders; it did not affect the Halifax agreement; and any approach adopted was adequately disclosed.            
• that Equitable, contrary to advice they had received that there was no need to allow policyholders to be represented at the convening court hearing, in answer to enquiries, should tell people the date of the hearing. FSA say that it would then be for the court to decide whether to hear any representations.
• that Equitable, as indicated: ‘introduce wording into the interim accounts and the Scheme circular to the effect that there had been some scope for doubt about the effect of the Treaty which has now been clarified, and to summarise the effect of the new Treaty’.

FSA provide the wording of a statement of their position to be used in the documentation, should their points be addressed.

The Economic Secretary to the Treasury writes to FSA’s Chairman to inform him she had agreed FSA’s recommendation that Equitable’s section 68 Order should be granted.

FSA’s Legal Adviser E writes to the Head of Life Insurance, Line Manager E, the Head of Actuarial Support, the Director of GCD and Chief Counsel A, having been passed a copy of the final reinsurance treaty on 16 November 2001. The Legal Adviser says that:

This email is to record for our files my understanding that GCD has not been asked to advise on either the final version of the IRECO treaty as attached to this message, or (as yet) on any legal issues arising out of the credit to be taken for the agreement (as signed) in the Equitable’s returns. I understand that the reinsurance agreement is now in place.

Line Manager E circulates information received from Equitable on 16/11/2001 [17:13] on the value of the proposed uplift for GAR policyholders relative to the current value of the annuity guarantees being given up, following recent falls in current annuity rates.

Line Manager E says that:

There are two presentations – one before mis-selling claims are taken into account, and one after they have been built into the uplift factor. In my view the relevant numbers are those before mis-selling since mis-selling liabilities have not yet been factored into policy values and there could well be a [policy value] cut if the scheme is not successful.

While I think we accept that there has to be cut off somewhere, and that there may well be other factors that would also have to change if the issues were to be reopened to deal with falling annuity rates, it is helpful to see what the current offer means in practice.

Line Manager E explains that the comparisons show:

The worst case illustrated is a person aged 65 with a retirement annuity. Post scheme, if they wanted to take 100% GAR, their income would be 86.8% of what it would otherwise have been. If they took maximum tax free cash, this would increase to 91.6%. The position is only very slightly better for a male of 60, where the numbers are 87.8% and 92.1%. For women with the same policies, they would be a bit better off. As a rule of thumb, add 2½ to the percentages above.

For flexible GARs, the position is better for men, with the value of the market option at around 90-92% GAR if the fund is taken entirely in annuity form, and 96-98% if maximum tax free cash is taken. For women, the corresponding figures are again plus 2-2½.

From the information we have about people who could retire now, only where the policyholder would have taken a joint life annuity would they be better off without the GAR. (Of course, those who would not have exercised the GAR at all are clearly in the money.)

Line Manager E concludes by pointing out that:

Previously when we have undertaken this analysis, it was essentially the case that only those with retirement annuities and who would have taken 100% GAR would be any worse off (give or take 1 or 2%). Those with flexible products would have been slightly better off.

Equitable send FSA proposed wording on the reinsurance treaty to be included in their Interim Report and compromise scheme documentation. The wording is:

The Society entered into a reinsurance contract with Irish European Reinsurance Company (“IRECO”) in 1998. The treaty provided relief from the full solvency cost of Guaranteed Annuity Options in circumstances where GAR take-up rates exceeded 25% of the maximum exposure (subsequently amended to 60%). The effect of the treaty was to provide additional capital from the Reinsurer for the purpose of regulatory capital adequacy, which is reimbursed to the reinsurer out of future surplus.

The new Board became aware of a side letter in August 2001, which cast doubt as to the reliance that could be placed on the GAR reinsurance contract (notwithstanding the side-letter purported to be of no legal effect). An agreement has been reached with IRECO whereby the uncertainty has been removed and the GAR reinsurance contract remains in full force and effect. The Financial Services Authority was kept informed of the negotiations which resulted in the agreement.

[18:04] FSA’s Head of Life Insurance circulates the proposed wording, saying he thought it met FSA’s request and fitted with FSA’s Chairman’s ‘game plan’ for informing the Treasury Select Committee of events before the convening hearing takes place.

HMT send Equitable a section 68 Order to permit the calculation of the valuation interest rate in accordance with the approach in the Interim Prudential Sourcebook rather than the requirements of Regulation 69 of ICR 1994.

FSA write to Equitable to highlight a concern about what they had said in the scheme documentation about the Financial Services Compensation Scheme. FSA say that they thought that the policyholder documentation needed to refer to Consultation Paper 108 on the draft transitional rules of the compensation scheme, which:

… makes it (relatively) clear that the FSA view is firmly that the [Financial Services Compensation Scheme] would be required to exercise its jurisdiction. As [the documentation] is presently drafted we are in no doubt that chapter IX inappropriately makes too much of the contrary argument and as such could mislead investors (and I am told could fall foul of Part XIII of the Companies Act 1985).

FSA set out the amendments that Equitable should make and note that there should be no contradictory statements made elsewhere in the compromise scheme documents. FSA’s amendments include the insertion of the following text:

The [Financial Services Compensation Scheme] may be challenged in the courts on this and other issues by eg other creditors or other life companies (who are liable to fund the [Financial Services Compensation Scheme] through a levy). However, although there can be no legal certainty, the FSA considers that the operation of the [Financial Services Compensation Scheme] would not be negatively affected by [Article] 4.

FSA’s Head of Life Insurance sends Scrutinising Actuary F the comments made by the Director of GCD on the reinsurance treaty (see 12/11/2001 [08:28]).

On ‘Financial Information’, Equitable enclose a revised version of their Chairman’s letter.

On the other issues, Equitable repeat what they had said in an email to Managing Director B the previous day, which was:

Scope of Claims being Compromised. Page 47 of the Circular has been amended to retain rights for GAR uplift if any Non-GAR can exert a claim that he was missold to switch. Such person will not retain the right to a GAR, but to the Scheme uplift. Thus they do not fall to be [a] separate class. An understanding is to be given to the Court.

Convening Hearing. The Society fully accepts the FSA’s position with regards to the publication of the Convening Hearing. I understand from your lunchtime call with [Equitable] that if questioned the FSA will refer the issue to the Society, though expressing your regrets at the lack of public disclosure. You will appreciate that the Society will not share your sentiment in expressing regret.

GAR Uplifts. The two actuarial reports will contain words referring to the interest rates used. A draft of the [Appointed Actuary’s] words can be with you later today. [Equitable’s solicitors] and I have discussed the fundamental change issue, as it appeared in [a named] case. [Equitable’s solicitors’] view is that this would be a hostage to fortune and though the realistic estimate might change the true economic value is unlikely to alter fundamentally in a manner that results in greater uplift. At this very late stage the inclusion of a directors’ review process of economic factors is not considered feasible by [Equitable’s solicitors]. We will insert a Q & A on changes in interest rates.

Overseas Policyholders. I am advised that the wording of 5.1 of the Scheme is legally correct. It is standard practice to attempt to exert worldwide rights. However the Circular makes it clear that rights under local laws remain intact.

Equitable also say that the wording to be included about the reinsurance treaty would be sent to FSA that afternoon. Equitable thank FSA for the statement of their position, which was to be included in the scheme documentation.

[16:47] Line Manager E circulates Equitable’s response and the Chairman’s letter. The Line Manager says that, other than the issue of Equitable informing policyholders of the date of the convening hearing, ‘I believe our points are dealt with’.

Line Manager E goes on to say that, on the Chairman’s letter:

… they have tried to be constructive. I thought the tone and effect of the letter was quite good and met its objectives very well. However, since this arrived, I have taken a call from [Equitable’s Appointed Actuary] who is [concerned] about the inclusion of estimates of the fund for future appropriates, since the numbers are incorrect and he does not believe that they can be disclosed. He is talking to [Equitable] now. I did not comment on the substance of his concerns, but warned him that [Equitable’s Finance Director] had been seeking to respond to the concerns of the FSA by including “estimates” of key information of relevance to policyholders.

Line Manager E asks for any comments on this, and notes that: ‘At some point today, we were due to give comfort to Halifax. That is looking increasingly difficult at the moment, so we might need to suggest to Equitable that their board might have to take a decision subject to confirmation being received from us and Halifax’. He says that he would inform Halifax that they were making progress but ‘are not yet there’.

FSA have a telephone conversation with Equitable’s solicitors about the termination provisions in the revised reinsurance treaty. Following that discussion, Equitable’s solicitors provide FSA and Equitable with their observations:

1. Unless and until the Reinsurance Claims Amount at any 31 December exceeds £100 million, the rights of long-term policyholders in the event of the insolvency of the Society take priority over those of IRECO. This is exactly as before.
2. If the Reinsurance Claims Amount at any 31 December exceeds £100 million, then as part of the additional amounts payable to IRECO, a one-off Additional Premium of 12% of the credit taken by the Society at that 31 December is payable. This is available to IRECO as security in the event of the Society’s insolvency against:
   1. any outstanding basic annual premiums (likely to be no more than £700,000 adjusted for [the Retail Prices Index]);
   2. any cash payments advanced (no more than 10% in any one year); and
   3. any outstanding Reinsurance Claims Amount (already the subject of set-off in the original).

Any balance must be returned to the Society – see the penultimate paragraph of Article XII.

In every other respect apart from the security over items (a) and (b), which we suggest is an entirely reasonable and foreseeable element of the renegotiation, the rights of long-term policyholders are as before.

In any event, we suggest that the existence of the security is no reason to alter the credit which the Society is entitled to take for the reinsurance, for the following reasons:

1. The “security” nature of the Additional Premium means that appropriate provision will presumably be required (by the FSA if by nobody else) to be made for its non-return in the Society’s accounts as soon as it becomes payable. If that is done, and any loss likely to result to long-term policyholders is factored in, there is no reason for any reduction in the credit taken, because no further detriment will result on insolvency.
2. At most, the detriment [to] long-term policyholders from the provision will be the extent of the one-off Additional Premium, and no greater reduction in the credit permitted can be justified. The absolute maximum would be 12% of the sum for which credit is sought to be taken. Given that the FSA has already required the Treaty to cover 120% of the amounts for which credit is to be taken (there was no such provision before), even this would seem hard to justify.

We are confident that the point was understood by those at the FSA who looked at the revised treaty before it was signed, particularly given some of the changes that we asked to make, but we appreciate that you have been required to look at this afresh, and it is a complex arrangement.

[23:40] FSA’s Head of Actuarial Support informs Chief Counsel A that he believed that there was only one Additional Premium payable under the contract and it did not recur every year.

[FSA’s Head of Actuarial Support] has reviewed the … note [by Equitable’s solicitors of 20/11/2001] and confirmed to me that he is happy that we tell Equitable that we will accept a provision. We cannot yet say what amount we will accept, but can say it will be at least £250m (although probably no more than £600m). Because the analysis is not yet complete, we cannot be more definitive. If you are content to accept this for the purposes of the Equitable’s Board meeting tomorrow at 10am, you would also be accepting reliance on [the solicitors’] legal view of the meaning of the Treaty. We do not know whether Equitable management would be prepared to recommend to the Board that it decide to proceed to the convening hearing on this basis. Their position so far is that the need to disclose any negative information concerning the Treaty (including reduced provision) will mean that the Scheme cannot go forward. This seems to [the Head of Life Insurance] and me unreasonable, but we cannot be sure to what extent this is a bargaining position. Clearly it would be undesirable in the extreme to be labelled as having brought the scheme down, but on the other hand we have told the Equitable repeatedly that we will not be bounced. [Equitable’s Appointed Actuary] first wrote to FSA about the amount of provision which could be taken by letter dated 16 November to [the Head of Actuarial Support]. I do not know when the letter was received by FSA, but it appears it may not have come in (or been seen) until 19th.

In response to Chief Counsel A’s last note of the previous evening, the Head of Life Insurance says that the relevant issue for FSA was whether they should let their non-objection to the compromise scheme stand, despite their remaining doubts about the credit that could be taken, or whether this was sufficiently important to justify FSA being the cause of the failure of the scheme.

[09:09] Chief Counsel A prepares a draft Notice to deal with the possibility that Equitable decided not to proceed with the compromise scheme until the matter was resolved in a situation in which FSA wished to require them to do so.

FSA’s Head of Life Insurance writes to Managing Director B, following an internal meeting and subsequent conversation with Equitable about the current position on the documentation for the compromise scheme.

The Head of Life Insurance records:

We said that the FSA stood by my letter of the 19th November to [Equitable’s Chief Executive]; if the Board was satisfied that the Society had met the points set out in that letter, then the documentation could include the statement of the FSA position set out in that letter but we had not yet seen the revisions to the documentation which reflected those changes, so the onus would be on the Board to satisfy itself that our points had been met. We ourselves could not confirm that until we had sight of the revised documentation.

The Head of Life Insurance continues:

The most difficult issue was the terms in which the amended Reinsurance treaty was described. We believed that the wording proposed by the Equitable was misleading, since they implied that the amount of credit which could be taken for the reinsurance was exactly the same as under the original version. The wording needed to describe accurately the effect of the Treaty. [Equitable’s Finance Director] said that he believed their latest formulation did this, but we had not yet seen it. We said that it was important for us to reach a firm view on the quantum of credit which could be taken; we asked, and [Equitable’s Finance Director] agreed, that [Equitable’s Appointed Actuary] would come to FSA as soon as possible after the Board Meeting to discuss this with our actuaries and lawyers, with the aim of reaching agreement today. We added that it was our view that it was not necessary for the wording on the Reinsurance Treaty to be in the documentation which went to the convening hearing provided that it was made clear to the court that additional information on this point would be made available in the documentation before it was sent to policyholders. [Equitable] took note of that suggestion; but added that a letter of non-objection from the FSA to the Halifax would still need to be sent before the court hearing, otherwise Halifax’s Agreement (and with it the extra £250 million) would not be obtained.

Equitable send FSA the latest version of the compromise scheme circular on which approval was sought that day.

[15:08] Line Manager E replies with fourteen comments.

[18:46] FSA’s Insolvency Practitioner provides observations and comments, which included the following:

Financial position: I think there is just about adequate disclosure although it would help if three facts were pulled together in one place. The Society says … that there is no material change in financial position since June (ie the fund for future appropriations is still about £1bn); the Appointed Actuary says that the GAR costs increase by £350m for each 1% fall in interest rates …; and the Interim Accounts disclose that misselling costs could be in excess of £850m. Taken together I think policyholders can adequately assess the risks of “struggling on” compared to voting for the scheme.’;

… do you think that your/the Society’s calculations of how much worse off GAR policyholders close to retirement might be (87% to 92%) If no cash is taken (10% of GARs) will be disclosed to the court at either the convening hearing or the sanctioning hearing either by us or the Society. I think it should be.;

and,

Finally, I wondered whether there is another class of misselling …

I had not appreciated until now that about 75% of policyholders have a 3.5% guaranteed return. As policy values have been or are at risk of being cut to fund these guarantees (since on maturity it is the higher of the guaranteed sum and policy value which the Society pays) there is an argument that the 25% of policyholders without such a guarantee have been missold because they were not informed that 75% of other policyholders had such rights. ie another example of mixed bathing. The quantum of such a “loss” might fall away as solvency improves, but this might be an issue if it does not.

[12:17] Chief Counsel A passes the Director of GCD’s note about set-off rights to Counsel.

[12:42] Counsel sends Chief Counsel A his own note on the issue of set-off rights.

Equitable send FSA a draft paper by their Chief Executive on the risks arising from different investment approaches. The paper includes an analysis of those risks, followed by an assessment under four scenarios, those being:

• scenario 1 – exiting equities at £1bn per month;
• scenario 2 – exiting equities at £0.5bn per month;
• scenario 3 – maintaining equities in current proportion; and
• scenario 4 – following current investment call.

In conclusion, the Society’s Chief Executive says:

1. PRE has been shaped in recent months by the proposed compromise pack, the roadshow and statements to the media. These do not flag up a declining proportion in equities – rather the reverse.
2. Because of (i) above, the possible investment scenarios are 2, 3 and 4. Scenario 1 would require a significant restatement of investment intentions.
3. The recommended central route is scenario 3 with scenarios 2 and 4 available to the Investment Committee depending on their conviction of the accuracy of the current investment call.
4. The Board needs to be aware that this investment stance is not appropriate unless they believe the market to be relatively low, with a greater upside than downside potential. The degree of risk would be inappropriate for a long term insurer in normal markets. By contrast, this or a greater degree of risk would have been entirely appropriate in 1974.
5. If scenario 1 is followed, the fund will be locked into, effectively, a weak non-profit style. Guaranteed bonuses may be secure and it may be possible to pay final bonus up to nearly 5%. The downside and upside potential of equities would be reduced. If the next equity upturn is missed, it is likely that the fund will be permanently under-performing in the way alleged by [a named Member of Parliament], (presumably having been briefed by [Independent Financial Advisers]). The rate of exit through legitimate churning in those circumstances would lead to high exit rates. There is also an increased risk that the Society could not cope if litigation and mis-selling risks increase still further.
6. A negative FFA (Fund for Future Appropriation) does not constitute insolvency [This needs to be checked] but it is clearly highly undesirable unless it is for a very brief period.

FSA’s Chief Actuary C informs the Head of Life Insurance and Managing Director B that he had completed his review of the reinsurance treaty and had also received a telephone call from Equitable’s Appointed Actuary about the treaty. He sets out two ways in which the treaty differed materially from the original one and states that:

In summary we believe that it is reasonable to assume that the amended treaty has a slightly reduced effect (about 12% reduction currently) compared with the original treaty but the effect could be greater in future, depending upon the future course of investment conditions, as a result of the cap [to the reinsurer’s liability should the cost of providing GAR benefits increase]. Equitable have told us that they believe that they can take £600m credit for the amended treaty and, in the light of our review and the discussions, we have no reason to challenge that.

Equitable’s solicitors send FSA a note on set-off and subordination of the reinsurance treaty, as had been promised in a conversation earlier that day. The solicitors say that they remained of the view that there was no justification for any disallowance in the credit taken by Equitable for the treaty up to the self-imposed limit of £833.3m.

[18:55] FSA send Counsel a copy of the note.

Equitable send FSA a draft version of their interim report for the half-year ended 30 June 2001, prepared under the Companies Act.

FSA hold a telephone conference with Counsel to receive his preliminary oral opinion on the reinsurance treaty. Scrutinising Actuary F’s handwritten notes of the conversation include the following:

• Purpose of [the original] treaty was to enable [Equitable] to meet [the solvency requirements] but not to provide cash … cash only expected to be needed to meet reserving [requirement] but such cash [would] need to be repaid from future surplus.
• [Counsel’s] view: that side-letter adds nothing to [Article] XIII as was; there was no need to [renegotiate] if [the Reinsurance Claims Amount exceeded] £100m; if IRECO got awkward when [the Reinsurance Claims Amount exceeded] £100m, could end up in arbitration in Ireland. Likely outcome unknown.
• Could [Equitable] call [in the Reinsurance Claims Amount] in cash? [Equitable’s solicitors] said no. [Chief Actuary C] said makes treaty worthless then. [Counsel] agreed.
• Need clarity that [the Reinsurance Claims Amount would] be [payable] in cash by IRECO on [liquidation, otherwise] only thing you can take credit for is the 10%.

Equitable complain that FSA had changed their view on the effectiveness of the reinsurance treaty, after giving their consent for the compromise scheme documentation to be approved by Equitable’s Board. Equitable say:

For us to proceed with the Scheme we require clear guidance as to what amendments are needed to the Scheme to enable the FSA to withdraw today’s objections. We need this in writing as a matter of considerable urgency. We need the FSA’s concerns in writing no later than close of business today.

From the telephone message received from [The Head of Life Insurance] this afternoon are we right to conclude that the attached letter [the ‘no objection’ letter sent to IRECO on 15/11/2001] was sent before the FSA completed its internal sign off procedures?

Scrutinising Actuary F provides FSA’s Chairman and Managing Director B with a ‘ball park’ indication of the amount that Equitable could claim for the reinsurance within their returns. The Scrutinising Actuary explains that the calculation ‘is based on the cash amounts which Equitable can request from IRECO under the treaty’. The Scrutinising Actuary then explains:

We have assumed that the value of the liability passed to IRECO is £700m, and that the value of the premiums due from Equitable under the treaty is £100m.

On the assumption that the cash amounts are drawn down evenly over a 10 year period and discounted at 7.5% p.a. representing a valuation rate of interest of 4% + the interest “turn” of 3.5% on the amounts drawn down (i.e. assuming that LIBOR can be earned on the cash drawn) then the £700m. is only worth 68% of its face value i.e. £480m.

The maximum amount that we believe can be taken credit for is therefore £380m. (i.e. £480m. less the premiums due of £100m.).

On a copy of his note, Scrutinising Actuary F writes:

We concluded during the [telephone conference] with [Counsel] et al that no credit could be taken for [the] Reassurance Claim Amount itself for reserving purposes because that was always held back by IRECO and never paid across, even on termination.

The only thing for which credit can be taken for provisioning purposes is the cash which can be drawn down, even though the treaty wording is poor.

FSA’s Director of GCD seeks clarification from Scrutinising Actuary F, asking:

… you explained that the [£]700m was your calculation of the amounts that could be claimed in cash under [clause] 4. I take it that in reaching your view on provisioning, you were happy that no account needs to be taken of the points made by counsel that:

• [clause] 9b means that on termination these amounts are to be repaid, and
• post termination, no future amounts can be claimed.

FSA reply to Equitable, saying that they had informed IRECO that FSA had no objection to Equitable entering into the renegotiated treaty and that this remained their position. However, FSA say that they had not committed themselves to the level of credit that could be taken. FSA state that Equitable should not take credit in their returns of more than £350m for the reinsurance arrangement. FSA provide a form of words for describing the situation, that FSA would be happy with, while noting that it would be a matter for Equitable to decide how to present the issue. FSA say:

The FSA believes the treaty does not call into question the promotion of the Scheme by the Board, but recognises that proper disclosure of the issue should be made so that members are not misled as to the financial position of the Society for regulatory purposes.

Line Manager E sends Chief Counsel A a copy of the note prepared by the Head of Actuarial Support on 12/11/2001 [09:57], setting out where FSA had got to in their assessment of potential mis-selling liabilities.

[12:25] Chief Counsel A forwards to Legal Adviser E the note received from Line Manager E earlier that day on mis-selling. She says: ‘I have now started “screaming” about the need to get this work done, but nothing can happen now until [the Head of Actuarial Support] is back from leave’.

Chief Actuary C writes to FSA’s Chairman, Managing Director B and Director of Insurance about Equitable’s current financial position, following discussion with Scrutinising Actuary F and Equitable. The Chief Actuary says:

Since the end of October the position has changed as follows:

We were told that the Board had decided to sell £500m of equities over today and Monday. This would reduce their equity backing ratio from 35% to 31%.

We explained to [Equitable’s Appointed Actuary] the underlying basis that we had adopted in assessing the revised value of the treaty and he did not appear to have any problem with the principle.

In response to the Director of GCD’s queries (of 22/11/2001 [21:23]), Scrutinising Actuary F explains:

£700m. was calculated by Equitable and represents the amount of the liability removed from Equitable’s balance sheet and passed to the reassurer. This is the present value of the Reassurance Claims Amount. Our understanding of the treaty is that this £700m. could all be drawn down in cash. However because only 10% of the withheld reassurance claims amount can be drawn down in any year, there is an additional time lag of up to 10 years before the cash can be fully extracted. Allowing for this, the discounted value of the cash payments is £480m. Against this amount needs to be offset the premiums payable by Equitable to IRECO.

I confirm that we have disregarded the obligation of Equitable on termination to repay the amounts drawn down. The actuarial valuation does not address the position on insolvency since it is done on a going concern basis and presumes that insolvency will not arise.

I also accept that post termination no future amounts can be claimed. This does not affect our calculations because termination is not expected to take place on the actuarial basis used.

[12:04] Chief Counsel A asks the Actuary whether, by premiums payable, he had meant the Adjustment Premium and the Deposit Premium.

[12:27] Scrutinising Actuary F informs Chief Counsel A that he had been referring to the Deposit Premiums, which were not dependent on future surplus, and the parts of the Adjustment Premiums which were also not contingent on future surplus, those being the Additional Premium and the Additional Fee.

[14:47] Scrutinising Actuary F also tells Chief Counsel A that the Additional Premium was payable only once.

FSA’s Head of Life Insurance seeks comments on a draft letter from FSA’s Chairman to the Treasury Select Committee about Equitable and the reinsurance issue.

[14:28] Chief Counsel A comments that:

There is a further matter for all to think about. This letter does not mention that as [a] result of further advice from Counsel, the actuarial advice has been revised (possibly subject to further input from Equitable on the underlying numbers) and provisioning taken at a lower level. Does that make this letter misleading? Perhaps not. Arguably the first reinsurance agreement was worth (and always was worth) only £100m as a result of the uncertainty raised by the side letter. And in any event we have still not come to a final view on the implications of [Counsels’] further advice. But the further legal advice and its implications will undoubtedly become public at some point so we should think about how others may view this letter in the light of that now.

[14:57] Chief Actuary C says: ‘It is true that as a result of further advice from Counsel we now believe that the treaty is worth less than we previously believed to be the case (prior to disclosure of the side letter). If you wish to disclose this change of view then it would fit most naturally in the paragraph on page 2 that begins “The Equitable has now advised …”’.

Counsel send FSA a draft joint opinion regarding the IRECO reinsurance treaty.

(Note: the opinion was finalised by Counsel on 3 December 2001 and sent to FSA the following day. I have seen that final version. I am satisfied that the final version of the opinion does not differ substantively from either the preliminary oral opinion provided by Counsel to FSA on 22/11/2001 (see entry 4 for that date) or from this version.)

The draft says that the scope of the opinion sought by FSA was as follows:

We have been asked to advise as to the meaning of the provisions in the new treaty with the rights and obligations of IRECO and the Society on termination of the agreement. In particular we have been asked to consider whether the provisions in the new treaty are the same or materially different from the corresponding provisions in the original treaty.

We have been asked not to advise on the general effectiveness of the original or the new treaty, either as between the Society and IRECO, or in relation to the reserving obligations imposed upon the Society under the Insurance Companies Act and associated regulations. We have also been asked not to consider in any detail the meaning and effect of the provisions of the new treaty which apply in the event that the cumulative Reinsurance Claims Amount for which IRECO is liable under the new treaty exceeds £100 ­million.

Under the heading ‘Summary of the original treaty provisions’, the draft includes that:

The effect of termination of the original treaty under paragraph 2 of Article X would have been that for the future IRECO would be under no further obligation to make any annual cash payments to the Society under Article IV. Moreover, no further Reinsurance Claims Events would occur and IRECO would not be “liable” for any further increase to the Reinsurance Claims Amount.

So far as any Reinsurance Claims Amount outstanding as at the date of termination is concerned, we believe that notwithstanding the use of the word “liable” in the first sentence of Article IV, there is no basis under that Article for concluding that IRECO could be called upon to pay any such amount to the Society, either during the lifetime of the original treaty, still less after its termination. This is because Article IV also states that the Reinsurance Claims Amount will be “withheld” by IRECO.

IRECO’s only payment obligation under Article IV was to pay on request on any 31 December what was described as an “interest amount” or a cash payment of up to 10% of the Reinsurance Claims Amount. This obligation could not be triggered by any requests for payment made after the contract had come to an end.

The draft opinion says that:

In short, the true analysis of Article IV is that whilst the original treaty remained in existence, it contained a mechanism for calculating an annual liability of IRECO to pay cash to the Society, which was expressed either as an interest amount or as a cash payment of up to 10% of the Reinsurance Claims Amount. It did not create any obligation on IRECO, either during the life of the treaty or after its termination, to pay to the Society the larger amount, namely the Reinsurance Claims Amount.

The provisions of Article X as to termination do not affect this analysis.

On what would happen in the event of a liquidation, the draft opinion says:

… the term of Article X providing for the subordination of IRECO’s right to a refund from the Society only applied in the case of termination following a liquidation of the Society. The effect of the subordination provision in that event was that IRECO’s rights to claim a refund of the interest/cash payments which it had made to the Society would be subordinated to the claims of the Society’s long-term policyholders in the liquidation. In other words a liquidator of the Society could resist a claim by IRECO for payment of such amounts (or for a distribution in respect of them) until after the Society had discharged its liabilities to its long-term policyholders.

The drafting of the original treaty is obscure and these key provisions are difficult to interpret. We are, however, confident that if it had been intended that termination of the original treaty following liquidation of the Society would result in the liquidator being able to demand payment of the Reinsurance Claims Amount from IRECO to meet the claims of the Society’s long-term policyholders, the treaty could and would have said so in terms.

Turning to the renegotiated reinsurance treaty, Counsel note that ‘the new treaty contains a number of new provisions designed to deal with the situation which will apply in the event that the cumulative Reinsurance Claims Amount exceeds £100 million’. The draft opinion says that:

… it seems to us that paragraphs (a) to (f) of Article XII have the following effect:-

1. under the first sentence of paragraph (a), upon termination of the new treaty, the Society will be obliged immediately to pay to IRECO in cash any unpaid Deposit Premium and Risk Amount;

2. under the first sentence of paragraph (b), upon termination of the new treaty, the Society will be obliged immediately to repay to IRECO in cash any cash payments which were made to the Society under Article IV and to pay any accrued fee interest thereon under Article V;

3. any other rights and obligations existing as at the date of termination between the Society and IRECO will be immediately subjected to the creation of equal and opposite obligations under paragraph (d) which will be set off against each other under paragraph (e). This will have the effect that except for the Society’s obligations under (a) and (b), no other sums will be owing between the Society and IRECO following termination; and

4. paragraph (f) expressly confirms that following termination of the new treaty, apart from the Society’s debts to IRECO created under paragraphs (a) and (b), the Society and IRECO will be mutually released and discharged from any further rights and liabilities under the new treaty.

Accordingly, leaving aside the proviso, upon termination of the new treaty, IRECO will be discharged from any liability to the Society in respect of the Reinsurance Claims Amount, but the Society will be obliged to make payment of any arrears of premium owed and to repay any cash received under the treaty.

This means that the provisions of the new treaty do not differ from those of the original treaty if termination occurs on the giving of notice following the occurrence of any of the events set out in paragraphs 3, 4, 5 or 6 of Article XII.

Counsels’ draft opinion then sets out their views on what would happen if the reinsurance treaty were terminated following the insolvency of Equitable. The opinion concludes, in summary, that:

Under the original treaty, IRECO could not claim payment or a distribution on account of arrears of premium or refunds of any amounts which it had actually paid to the Society on request under Article IV unless or until the Society had paid its liabilities to the holders of its long-term policies in a liquidation.

However, under the new treaty, its seems to us that there is no such subordination, and in a winding up of the Society, IRECO could claim such amounts in competition with the claims of the Society’s long-term policyholders.

The draft opinion also concludes that:

In our view, the entire Reinsurance Claims Amount never became due and owing by IRECO to the Society under the original treaty. The position is the same under the new treaty. The situation after termination of either treaty following the insolvency of the Society would be no different.

Further to Scrutinising Actuary F’s comments on reinsurance of 23/11/2001, the Director of GCD states that Counsel had advised that the Reinsurance Claims Amount did not constitute a liability and so must be left out of account and that only the income stream could have a value in the returns.

[10:45] The Director of Insurance says that he did not see the difference between the two positions and that: ‘I had thought that what was being valued was an annual income stream of 10% of £700m. The actuaries are prudently (over prudently?) assuming that this should be calculated by reference to £700m rather than £1bn, which is the maximum permissible under the treaty because presumably £700m is 100% of the amount for which credit was previously taken’.

[10:56] Chief Actuary C explains that the £1bn represented the maximum claim against the reinsurer should economic conditions vary adversely in future and that it would not, therefore, be appropriate to place a value on this amount unless and until the adverse condition arose.

FSA’s Scrutinising Actuary F informs the Head of Life Insurance that the Chairman’s letter to the Treasury Select Committee might not have been correct on one point, being that the reinsurance treaty did not have any impact on the value of the with-profits fund. The Scrutinising Actuary agrees that the treaty had not added any value to the fund but points out that it did have a negative impact on the fund in the premiums that had to be paid. He suggests that the letter should have said that the treaty has ‘no beneficial impact’ on the fund.

The Scrutinising Actuary points out that this statement had not been included in the version of the draft that he and Chief Actuary C had reviewed.

[11:45] The Head of Life Insurance thanks him for the explanation.

FSA issue a press statement about the disclosure of the side letter to the reinsurance treaty. The statement says that FSA:

… took the view that the contents of the letter raised questions about the true value of the reinsurance contract that Equitable Life had entered into in early 1999 and which was shown in its regulatory returns. The FSA concluded that, had it been aware of the letter at the earlier stage, it would not have been prepared to accept the reinsurance arrangements as providing as much security for reserving purposes as was in fact taken.

The statement goes on to say that FSA:

… has seen and reviewed the terms of a renegotiated reinsurance agreement and has confirmed that it has no objection to them.

However:

… in the light of advice from leading Counsel, the FSA has taken the view that the value that Equitable Life should reasonably ascribe to the reinsurance contract is lower than it previously took. The FSA has made clear to Equitable Life that it must properly disclose the effect of the revised agreement, so that policyholders are made aware of the impact on Equitable [Life’s] financial position for regulatory purposes.

FSA state:

On the basis of the information received by the FSA, Equitable Life continues to meet its regulatory solvency requirements even taking account of the lower credit for the revised reinsurance policy.

[11:26] FSA’s Press Office circulates Q & A notes, setting out the line to take on the announcement.

FSA’s Chairman’s Office asks Chief Actuary C, in response to his note of 23/11/2001 [11:08], to clarify whether the section 68 Order added anything to Equitable’s financial position.

[12:16] Scrutinising Actuary F replies, having spoken to Equitable’s Appointed Actuary, saying that the figures already anticipated the effect of the section 68 Order and included the benefit estimated at £200m. He adds: ‘The effect of the S68 Order is that credit is now taken in the main valuation result for profits which would have emerged in the future. I therefore asked [Equitable’s Appointed Actuary] whether the implicit item for future profits (estimated below to be currently worth £800m.) has been reduced accordingly. [The Appointed Actuary] is checking that out, and will confirm the position a.s.a.p. He did say though that he thought there were margins present in the implicit item’.

Equitable’s solicitors send FSA a copy of a statement by the Society’s Chief Executive, which had been filed with the court.

[21:02] Chief Counsel A comments that the changes which FSA had requested on Article 4 in relation to the policyholders’ compensation schemes had not been made.

Equitable send FSA a balance sheet, profit and loss statement and a comparison of policy values to allocated assets as at 31 October 2001. This provides the following information:

Following a request from Chief Counsel A, Chief Actuary C provides comments on Counsel’s opinion on the renegotiated reinsurance treaty. Having checked the opinion with Scrutinising Actuary F, he says that the opinion did not conflict with their recollection of the advice that had been given over the telephone last week and that FSA would not change their view on the credit that could be taken in the returns for the treaty. Chief Actuary C continues:

We have one comment to make on the draft Opinion in paragraphs 19 and 20. Those paragraphs refer to the Society being required to repay any interest amount or cash which the Society had earlier been paid. We are surprised that this obligation requires the Society to repay interest amounts based on the construction of Articles IV and X. In Article IV cash payments appear to be defined as the 10% amounts and Article X appears to refer explicitly to the cash balance. Why therefore do interest payments fall to be repaid under Article X? I believe that this point is less ambiguous under the new treaty wording of Articles IV and XII(b), where the latter Article refers explicitly to cash payments.

An issue that we would prefer to see within the Opinion is whether or not there is any obligation for the Society to repay cash payments received, other than under Termination Article. We are relying upon the fact that no other obligation for repayment exists.

[18:13] Chief Counsel A thanks him for the comments and says she would forward them to Counsel.

The following day [at 14:14], Chief Actuary C sends the correspondence to the Head of Life Insurance.

FSA’s Head of Press Office provides Managing Director B with information on the press coverage of the disclosure of the side letter. The Head of Press Office says: ‘From their reaction yesterday, the bit the Equitable will be most fussed about is the possible creation of a new class of “missold” policyholder to make claims on them – ie anyone after 1 April 1999 – on the grounds that we are bound to have closed Equitable earlier had we known of the impaired reinsurance’.

[09:32] The Head of Life Insurance adds: ‘[Equitable’s Chief Executive] told me last night that he was surprised and (by implication) upset at the sentence in our [press notice] about not allowing so much credit had we been aware of the letter at the time – for exactly the reason that it might open a line of claim for misselling by late joiners. He seemed to think that this sentence was a “toughening up” of the [press notice] from the version they had seen. I said I was not aware of that; indeed, we had removed another sentence to meet concerns expressed by [Equitable’s Finance Director] over the weekend’.

[09:35] Managing Director B states that this was his understanding.

[10:37] The Director of GCD comments that ‘the risk of claims is inherent in the underlying reality’. He explains that there had in fact been a small change to the final text, which ‘was needed to ensure [it] was not misleading given advice from counsel’. The Director of GCD concludes that he did not think this made any difference to the press coverage.

FSA’s Head of Actuarial Support comments on the balance sheet provided by the Society on 26/11/2001, saying:

I see this includes an amount of £695 million for the reinsurance asset, rather higher than I would have expected. It also includes an implicit item for £805 million of future profits for which they do not have a waiver under [FSMA 2000], I assume. Against this, the actuary claims that they could discount the guaranteed liabilities rather further, though this has not been demonstrated.

FSA’s Chief Actuary C informs Chief Counsel A that:

We have identified a further material change to the IRECO Life Reinsurance Agreement that does not appear to have been covered by the Opinion.

Under the original treaty, the interest payable on cash drawn down under Article IV appears to be payable by Equitable to IRECO as part of the Adjustment Premium, as set out in Appendix II. The Adjustment Premium, and hence the interest payable on the cash draw downs, is payable out of emerging surplus and hence the Appointed Actuary needed to make no provision for the interest payments in setting his mathematical reserves.

Under the new treaty, the interest payable on cash draw downs is separated out from the Adjustment Premium and is shown in Article V under the Heading “Fee if interest or cash paid by the Reinsurer under Article IV”. It appears that this fee is payable in cash each year whether or not surplus emerges to cover it.

This change is significant and could have a further adverse effect on the amount that Equitable could claim for the treaty in their regulatory returns because full provision for the future interest payment cost may be necessary until the eventual termination of the treaty. In assessing the £350m provision we had provided for the interest cost for a 10 year period. [Scrutinising Actuary F] is trying to assess the effect of this but it may result in the treaty being of little value.

[15:22] Chief Counsel A says that she: ‘[does] not read the fee of LIBOR plus 3.5% as forming part of the Adjustment Premium under Appendix II of the original agreement. I can see however that there is a contrary argument which arises primarily as a result of the placement of the fee obligation in the middle of [Appendix] II. I will run this by Counsel’.

FSA’s Scrutinising Actuary F sends the Head of Actuarial Support a spreadsheet which tracks how the reinsurance treaty might operate in practice. The Scrutinising Actuary says: ‘The value of the treaty to Equitable would be represented by the entries in the final column. However, as these figures decrease to zero over years 15 – 30, I wonder whether any value can be ascribed to the treaty in the first place’.

The Scrutinising Actuary also attaches a draft letter to Equitable in response to theirs of 16/11/2001.

FSA’s Chief Counsel A sends the Head of Press Office a copy of the Insolvency Practitioner’s comments about the compromise scheme of 21/11/2001 [18:46]. She says:

The two issues which seem to me most likely to arise now on the section 425 scheme (for press office) are the risk posed by [Article] 4 for compensation of Equitable policyholders in the event of insolvency and the risk to solvency of GIRs (75% of policyholders have them) and of misselling claims by non-GIRs.

FSA’s Scrutinising Actuary F asks Chief Counsel A and the Head of Life Insurance to review a revised draft of the letter to Equitable, in response to his letter of 16/11/2001 in relation to the credit to be taken for the reinsurance treaty. The Scrutinising Actuary explains that he had: ‘worked up a draft response … last week, but we felt unable to issue it at that time. I have now adapted the response to explain our view that credit can only be taken for the cash payments available under the treaty, and attach a copy herewith’.

The opening section of the draft letter reads:

We have consulted with leading Counsel on the legal interpretation of the treaty, and have concluded that no credit can be taken for the Reinsurance Claims Amount itself when determining the amount of the Reinsurer’s Liability for the purposes of the regulatory Returns. This is because, under Article IV, all Reinsurance Claims Amounts will be withheld by the Reinsurer, and never paid to the Society. Indeed, on Termination under Article XII, paragraph (d) of that Article would have the effect that an equal and opposite obligation to the Reinsurance Claims Amount would be created, and the two would then be set off against each other under paragraph (e) of that Article. So no sums would be owing between the Society and IRECO following termination.

It is therefore our view that the only benefit under the treaty for which credit can be taken for reserving purposes is the stream of cash payments of up to 10% of the outstanding (withheld) Reinsurance Claims Amount which can be drawn down under Article IV. It would be necessary though to allow for any premiums payable by the Society and any interest payments which are not subject to surplus emerging…

[19:35] Chief Counsel A says that officials should meet the following day to discuss the matter.

Scrutinising Actuary F sends Managing Director B a revised draft of a response to Equitable’s Appointed Actuary regarding the IRECO reinsurance treaty. The Scrutinising Actuary explains that this version of the draft incorporated the comments of Chief Counsel A.

The opening section of the revised draft letter reads:

It seems to us that the only benefit under the treaty for which credit can be taken for reserving purposes is the stream of cash payments of up to 10% of the outstanding (withheld) Reinsurance Claims Amount which can be taken under Article IV. It would be necessary though to allow for any premiums actually payable by the Society, and fees and any interest payment which are not subject to surplus emerging …

The draft letter also sets out a number of technical questions about the treaty. These include the comment that:

Your interpretation appears to be based on the assumption that credit could be taken in the valuation for the future Reinsurance Claims Amounts. As indicated above, we do not accept this.

(Note: the final version of this letter, which I have seen did not differ substantively from this draft, was sent by FSA to the Society on 13 December 2001.

Equitable responded to FSA on 9 January 2002. In response to FSA’s question above, Equitable says:

The Society’s interpretation is based on the assumption that credit can be taken in the valuation for the future Reinsurance Claims Amounts. I am not persuaded that the basis you set out in your letter, which is based on the stream of possible cash payments, is the only appropriate basis for valuating the reinsurance claims.

The Reinsurance Claims Amounts have been valued in full as shown in Form 52 of the Society’s statutory returns for the years 1998, 1999 and 2000. This basis was agreed at meetings of the Society with the FSA and the GAD in the first quarter of 1999 (where the GAD was represented by [the Head of Actuarial Support (who had at that time been GAD’s Directing Actuary B), Chief Actuary C and Scrutinising Actuary E] when the final terms of the Reinsurance Agreement were being agreed with IRECO to provide the required reserving credit for the reassurance. Apart from the level of GAR take-up required for a reinsurance claim, which was amended to 60% (from 25%) following the House of Lords’ ruling on 20 July [2000], the basis on which reinsurance claims arise under the Agreement has not been changed since the Agreement came into force and, in particular, nothing has been changed in this respect by Addendum 3 to the Reinsurance Agreement. It is clear from the Society’s statutory returns that it is this interpretation which has been used.

I therefore cannot see that Addendum 3 should require any change in the interpretation of the credit that can be taken for future Reinsurance Claims Amounts from that used in previous returns to the FSA and, that being the case, it is on this established basis that I should prepare the 2001 returns.

It appears that FSA conclude the correspondence on this matter with a letter, dated 19 February 2002, in which they state that: ‘For the record, we would mention that we do not agree with your contention that the basis that you describe in your letter, of taking credit in the valuation for future “Reinsurance Claims Amounts” rather than cash payments under the treaty, was agreed with us in early 1999’. However, FSA conclude: ‘now that the High Court have approved the Section 425 Compromise Scheme, we assume that the above reinsurance arrangement has been cancelled by Equitable. In addition we understand that the 2001 Returns are being prepared taking account of post-balance sheet adjustments in respect of the S425 Scheme. We do not therefore intend to pursue the matter of the value to be placed on the reinsurance any further’.)

Equitable’s Chairman and Chief Executive send out to the Society’s policyholders the final compromise scheme documents, which include:

• a booklet entitled ‘Your questions answered’;
• a ‘Scheme Circular’, setting out in full detail the compromise scheme proposals;
• the Society’s Interim Accounts for the half-year 30 June 2001, prepared under the Companies Act 1985.

In their letter, the Chairman and Chief Executive discuss the Society’s financial position. They write:

Interim Accounts for the half year ended 30 June are enclosed and are the first ever published by your Society. They provide you with financial information relevant to your voting decision. In the time available it has not been possible to produce third quarter interim accounts, but we should draw to your attention the financial impact on your Society during the third quarter of policyholder claims and the aftermath of September’s terrorist attacks in America which saw interest rates and stock markets fall.

Your Society is and remains solvent. This has in part been achieved by reducing our investments in the stock market and increasing holdings in lower-risk investments. At 30 June, some 48% of the with-profits fund was invested in the stock market. At 30 September that had reduced to 35%.

Since 30 June we have experienced an increase in policyholder maturities and surrenders as a result of the painful but necessary reductions in policy values. In the three months to 30 September these claims were £1.7 billion, though the rate of new claims has fallen since then. At 30 September, the with-profits fund was estimated to stand at £20.1 billion against £22.8 billion at 30 June 2001. This reduction was due to the claims and the decline in stock market values over the quarter exacerbated by the 11 September attacks.

At the end of September the Fund for Future Appropriations (which is available to pay bonuses) had fallen to an estimated £300m, but the total policy value for all with-profits policies compared to the value of the with-profits fund was within the 5% bounds set by the Appointed Actuary for the financial management of the Society.

The low level of free assets makes your Society financially unstable and vulnerable to market risks.

Your Board believes that adopting the compromise scheme is essential to make the Society more stable and place it on a stronger financial footing.

On ‘The benefits of compromise for policyholders’, the Chairman and Chief Executive say:

The adoption of the compromise scheme will see your current policy value increased in exchange for you giving up some of your rights. An indication of the uplifts are in your indicative statements of value, contained in your Voting Documents.

The successful completion of the compromise agreement by 1 March 2002 sees the Halifax £250 million used to uplift your policy funds. We believe that the compromise is still preferable to continuing as we are, even if this deadline is missed and uplifts are lower.

The compromise scheme will reduce uncertainty and worry for all policyholders and means we can invest the with-profits fund without the current abnormal constraints. The resulting improved financial position of the Society should ultimately lead to a less constrained bonus policy.

A successful compromise will not stop us from pursuing those who caused the Society’s problems, if that is in policyholders’ interest. However, any compensation is years away. We cannot wait – we must solve the Society’s problems now.

On ‘The dangers of no compromise’, the Chairman and Chief Executive say:

We have examined all the alternatives to a compromise. Either they do not work or would greatly reduce the value of your policy.

Liquidation would be very bad. All non-guaranteed bonuses could be lost. There is a risk that guaranteed benefits could be scaled back. Annuity payments including GAR pensions would be suspended and the competing claims of GARs and non-GARs might well delay payments for years.

No compromise means we do not gain the Halifax £250 million.

Without a compromise the Society would have to maintain a very restrictive investment policy, investing much less in stocks and shares. Bonus policy would need to be very cautious; payments might not include any non-guaranteed bonuses. A bleak outlook for policyholders.

The Government is clear that there will be no lifeboat for us and compensation for policyholders, if any arises, is years away. We cannot afford to wait. We must sort out our own problems now.

Finally, without a compromise the instability, uncertainty and worry will continue, and may well get worse for everyone, whatever their policy, whatever their age. We have listened to and read the views of many policyholders and know that this is rightly unacceptable to the vast majority.

Equitable’s Chairman and Chief Executive, on behalf of the Society’s Board, urge policyholders to vote for the compromise scheme.

FSMA 2000 comes into effect, changing the system of the regulation of insurance companies. The actions of the prudential regulators of insurance companies no longer fall within the jurisdiction of the Parliamentary Ombudsman.