1991

DTI write to Equitable’s Appointed Actuary with a set of papers that DTI had received from a policyholder concerning his complaint about the information he had been given when seeking to clarify two policies he had with Equitable. DTI comment that:

The various administrative errors evidently gave [the policyholder] little confidence in your Society. Moreover it is of concern that these errors and the faults in the administration system and records of the Society may have affected other policyholders of the Society.

I should be grateful for confirmation of the measures taken by the Society to rectify the position and to ensure that none of the policyholders of the Society were adversely affected. I look forward to receiving your comments.

In response to the note of 10/04/1991, the Government Actuary writes:

I think we would certainly want to discourage him from holding both positions, otherthan on a very temporary basis. It would be appropriate for DTI to write asking what[Equitable’s] intentions are regarding the appointed actuary position, bearing in mind thefact that it is not now generally thought desirable for the same person to be [ChiefExecutive] and [Appointed Actuary]. If they get a dusty response I will speak to [him].

DTI’s Line Supervisor A writes to Equitable. He says:

Since [the person] is currently the Appointed Actuary for the Society and it is considered desirable that the same person should not be both Chief Executive and Appointed Actuary, please would you confirm what the Society proposes regarding the Appointed Actuary.

Equitable write to DTI to confirm their position, following the telephone call. The Society say that they are of the view that the Appointed Actuary role should be regarded and operated at a senior and influential level. Equitable confirm that the Society does not currently have an actuary with the desired seniority but that they expect to have an appropriate person for the role of Appointed Actuary in 12 to 18 months’ time:

Accordingly, rather than moving away from the general approach and resorting to a purely technical interpretation of the Appointed Actuary’s role, we regard it as substantially more satisfactory in professional and business terms for [the person] to continue to undertake the Appointed Actuary role for a limited period longer, as mentioned above.

Equitable write to DTI in reply to the letter of 16/05/1991. Equitable say that it appears that theSecretary of State’s acceptance of the Society’s appointment of Chief Executive is conditionalon the person only continuing in the role of Appointed Actuary for a further 12 to 18 months.Equitable state:

Whilst it is certainly the Society’s current intention to separate the roles and appointanother Appointed Actuary in that timescale, we would not wish a condition to thateffect to apply to [the person’s] appointment as Chief Executive.

In making no objection to [the] appointment, the Secretary of State appears to acceptthat [the individual] is a “fit and proper person”.We cannot see that this will change if forsome at present unforeseen reason, [the person] does not cease to be the AppointedActuary within the timescale mentioned. There is, we believe, a point of principle here.

Naturally we recognise certain advantages in splitting the roles, which as I have indicatedwe intend to do, but would appreciate your acceptance of [the person’s] appointment ofChief Executive without the condition implied by your letter of 16 May 1991.

Line Supervisor A passes the letter to the DTI Line Manager with responsibility for Equitable(Line Manager A), with a note:

I do not think we can accede to [DTI’s acceptance of the appointment without condition].GAD consider 18 months is exceptional! Suppose [he] falls ill – no Chief Executive – noAppointed Actuary – a successor should have been groomed by now to take on role ofAppointed Actuary. I suggest we initially telephone [Equitable] to express our views – Icould not contact [the company] today.

Equitable’s Appointed Actuary writes to GAD’s Directing Actuary A, marking the letter ‘PRIVATEAND CONFIDENTIAL’. The Appointed Actuary refers to discussions they had had, when sittingtogether at lunch during a recent Institute of Actuaries seminar, about a number of things,including:

… the recent valuation and bonus declarations. It is very difficult, if not impossible, foryour colleagues and yourself to get any “feel” from the published results of the kinds ofdiscussions about actuarial management going on within life offices and it occurred tome that you would find copies of some of our relevant board papers helpful“background” reading. They extend beyond the purely appointed actuary role to that offinancial and actuarial management. Some of the figures were seen by [Chief Actuary B]at a meeting before the year end [see 14/11/1990].

The papers are of course confidential and offered as a good will gesture to promotegreater understanding and I should prefer restricted circulation within your department.

I realise, of course, that you cannot forget your supervisory role when reading thesepapers but I hope you will be able to accept them as an example of “steering” a board toacceptable conclusions. I have to hope also that I have not given a hostage to fortune!

The Appointed Actuary encloses with the letter Board papers from September andNovember/December 1990 (referred to by Equitable’s Chief Executive in the conversation on19/12/1990) and from January and February 1991, which were relevant to Equitable’s recentvaluation and bonus declarations. He also encloses a paper, dated March 1991, to the EquitableBoard on investment considerations for 1991. These papers are reproduced in full in Part 4 ofthis report.

In the disclosed September 1990 paper entitled ‘Valuation and Bonus Declaration at 31December 1990’, the Appointed Actuary explains: ‘The recent falls in world stockmarkets couldmean that we may face a more difficult position at the end of this year than has applied forsome time. Although the current position is very uncertain, it seems highly likely that theearnings on the fund at market value will represent a negative return over 1990. In view ofthat position, I feel it appropriate to begin discussion of some possible alternative courses ofaction rather earlier than normal’.

The Appointed Actuary goes on to discuss: the Society’s approach to smoothing the return onthe with-profits fund; the rate of bonus that he would like to declare; and the benefits ofallotting bonus in the form of final bonus. On the final point, the Appointed Actuary advisesthat final bonus:

… is not guaranteed, requires no capital to finance it and is only paid out on policiesleaving the fund. Hence it is very well suited to the situation where future earnings arebeing anticipated. If it eventually emerges that we have “got it wrong” the damage islimited and room for future manoeuvre is retained.

The Appointed Actuary then advises the Board:

In technical terms, any presentational problems created by declaring a bonus can almostcertainly be mitigated by weakening the valuation basis. There are, however, constraintson the extent to which that can be done. Once done there is then also no leewayavailable in a future year. Further technical measures are also available to help the DTIReturn presentation (but not the Company Act balance sheet). The use of such measureshas to be publicly stated and could be construed as a sign of weakness. Again, these arelargely “one off” measures.

The Appointed Actuary says that, if Equitable choose to allocate the entire bonus in the formof final bonus, their solvency position would be around £300m stronger.

The Appointed Actuary concludes by summarising the points made, as follows:

• unless there is a significant upturn in markets, it will be an uncomfortable year endfor bonus purposes
• interest rates have been relatively high for the whole year and policyholders might expect benefits based on returns ranging from about 12% to about 15%
• that could argue for maintenance of declared rates at last year’s level of £7.50%
• it might be possible technically to produce the required surplus for such a declarationbut this would necessarily be a “one off” operation. A bad year in 1991 would almostcertainly lead to even greater discomfort at the end of 1991
• declaration of a marginally lower rate would not really provide adequate savings insurplus. Declaration at a significantly lower rate would be difficult to justify andwould inevitably look weak
• we now show policyholders how their policy values roll up from year to year at anoverall rate of return. It should not really matter to what extent that roll up rate isconsolidated by way of declared bonus or left in unconsolidated or final bonus formproviding policyholders have confidence in us
• allotting the 1990 return in wholly unconsolidated form would retain a significantamount of freedom, freedom which might eventually be required in respect of 1991
• it seems to me, at this point in the year, that a case could be made either formaintaining declared rates at £7.50% or for having no declared bonus at all. Bothcourses of action contain significant risks. Maintaining declared rates would result in a significant technical and financial weakening of the Society whilst having nodeclared rate would run significant public relations risks. There seems no objectivebasis for an intermediate position and such a position would bring in train both typesof risk.

In the introduction to the disclosed November/December 1990 paper entitled ‘Valuation andDeclaration at 31 December 1990’, the Appointed Actuary says that there has been nosignificant improvement in investment conditions since his last paper to the Board. He says that‘consequently, it becomes increasingly likely that we shall not be “[bailed] out” by a dramaticimprovement in conditions before 31 December 1990’.

Under ‘Solvency and DTI requirements’, the Appointed Actuary writes:

The current regulatory regime does not permit the sort of action taken at the end of1974; there are now significant constraints. Any consideration of the position needs tobegin with an understanding of those constraints.

(Note: in response to the economic conditions during 1974 and in order to be able to maintainconsistent rates of bonuses whilst maintaining an adequate solvency position, Equitable hadchanged their valuation basis. These changes included increasing the valuation rates of interestused from an average rate of just under 6% in the 1973 valuation to 10% in 1974. In his witnessstatement to the Penrose Inquiry, Directing Actuary A said: ‘I do not know what specific sort ofaction, as happened in 1974, is referred to … but I can guess … In general terms, the paper isreferring to the fact that, since 1974, the UK had adopted new regulations governing the valueof assets and liabilities, and had introduced a solvency margin regime. These placedconsiderable constraints on companies which did not exist in 1974; similarly, in 1974, a degreeof flexibility was given to supervisors not allowed when the paper was written in 1990. Ibelieve that regulators in 1974 allowed companies to value liabilities on a much weaker basisthan would be allowed today, consistent with the yields available then. Reading from currentnewspapers, it seems the FSA is making some special arrangements now, to stop companiesfrom having to sell equities at the present time and so further depress the market. No similaraction was envisaged by DTI in 1990’.)

Equitable’s Appointed Actuary explains:

The primary requirement is for the office to demonstrate an excess of assets overvaluation liabilities. In fact there must be excess assets at least equal to the so-called“minimum guarantee fund” which, in the Society’s case, is 1/6th of the solvency margin(i.e. around £40m out of some £240m projected at 31 December 1990). If the actual excessof assets over liabilities is greater than the “minimum guarantee fund” but less than therequired solvency margin, then a special dispensation can be obtained from the DTI(called a S68 order) to bring so-called “implicit items” into account. In our case we coulduse an estimate of future surplus. The use of such orders might be regarded as showing aweak position by external commentators.

Assets must be valued on the basis set out in regulations which is, effectively, a marketvaluation. There is no room to manoeuvre on that side of the comparison. Anydifficulties on the public presentation can, therefore, only be overcome by changing thevalue placed on the liabilities.

The Appointed Actuary says that he has:

… freedom in the value placed on the liabilities, subject to the following regulatoryconstraints:

1. the reserves established must, in my professional opinion as the AppointedActuary, represent a proper level of provision for the liabilities based on “prudentassumptions”;
2. the reserves must, in any event, be no lower than those produced on a basis laiddown in regulations, coupled with additional requirements specified by theGovernment Actuary in relation to AIDS and “mismatching”. Mismatching isconcerned with looking at the situation if there is a ±3% change in interest ratesassociated with a 25% fall in the value of equities and property.We mustdemonstrate that our reserves are at a level such that the assets backing thosereserves would still cover reserves satisfying the valuation regulations in the changedconditions.

It is not necessarily the case that a valuation satisfying constraint (b) above will alsosatisfy constraint (a). In current conditions it is, however, unlikely that, given a free hand, Ishould want to place a value on the liabilities higher than that on the statutory basis.

Equitable’s Appointed Actuary states that he has:

… carried out projections on a range of bases to assess the effect of further marketmovements over the remainder of the year. These indicate that, except in the event of afurther sharp fall in markets before 31 December 1990, I should be able to set liabilityreserves at a level which would enable a bonus to be declared at last year’s level and stillsatisfy all the regulatory requirements. Looking at this year alone, it is, therefore, fairlyunlikely that we shall be unable to do what we should like.

Under the heading ‘Looking ahead to 31 December 1991’, the paper includes projections of theposition in the following year under different capital movement assumptions. The AppointedActuary explains: ‘In the projections I have assumed capital movements of -10%, 0% and +10%,in 1991. The income yield on the fund will be around 7% at current levels and so thesemovements are broadly equivalent to overall earnings of -3%, 7% and 17% respectively’. Theprojection for 1991 is presented as follows:

The Appointed Actuary goes on to discuss the Society’s approach to smoothing the returnsand the form of the allocation of bonuses.

In the disclosed January 1991 paper entitled ‘Valuation and Declaration at 31 December 1990’,the Appointed Actuary re-examines the issues discussed in his earlier papers. He reports thatthe first draft figures show a return on the Society’s investments of -8½%.

Equitable’s Appointed Actuary states:

As previously discussed, it is intended to increase the rate of interest used to value theliabilities in order to reflect the high asset yields resulting from current depressed assetvalues. I anticipate that the reduction in liability reserves arising from that will enablebonuses to be declared at 1989 levels without any transfer from the Investment Reserve. Indeed, I would expect the liability reserves, including new declared bonuses, to besubstantially below the closing fund of £5582m. That is, there will be a larger marginbetween asset and liability values in the DTI “Form 9” than simply the amount of theInvestment Reserve.Work is in progress on a detailed evaluation of the position and it isintended to provide further figures at the board meeting.

The Appointed Actuary sets out a ‘Review of the market’. From the bonus declarations alreadymade by certain other companies, he says that:

1. There is no evidence of an industry-wide move to cut declared bonus rates.
2. Offices generally are acting to smooth out, to a significant extent, the effects of low1990 earnings. Indeed, [a named other insurance company] has publicly spoken of earningsof 14% p.a. over each of the next 4 years and their 1991 results appear to imply at leastthat level of earnings deemed for 1990.

Under the heading ‘Considerations of the appropriate action for the Society’, Equitable’sAppointed Actuary reports the following:

In previous discussions we have felt that a deemed rate of growth in the region of 11/12%,which is consistent with the earnings underlying our declared rates, might be appropriatefor 1990. The actual outcome for 1990 and the actions of our competitors to datereinforce my view that this would represent a degree of smoothing consistent with ourstated approach to with profits business and the market …

Application of a total growth rate of 12% for pensions and endowment assurancebusiness would give the following changes in total policy proceeds on 1 April 1991compared with those a year earlier:

From the results quoted for other offices in paragraph 6 it would appear that these resultsshould broadly maintain our competitive position, and might marginally improve it.

As noted above, there is no general market move to cut declared rates. Dramatic action,such as passing the declaration altogether, would, in my view, carry an unacceptably highrisk of a collapse in confidence. The only circumstances in which it might be appropriateto re-open that question would be in the event of a dramatic collapse in markets during the next few weeks. (One office … has publicly stated that it is awaiting furtherdevelopments in the Gulf before finalising its bonus announcement.)

I have previously argued that current conditions give no logical basis for a cut in declaredrates. That remains my view. If we were to be one of the few offices to make a reductionin declared rates whilst maintaining the overall level to be allotted, then the publicitythat would attract could well counteract the effects of the overall announcement which,as noted above, seems likely to be reasonably competitive.We might, therefore, attractconsiderable adverse publicity for a relatively trivial financial benefit this year.

The course of action described above is not, of course, without risk. Although it has beenpossible to reduce the liability valuation to permit a declaration at last year’s level, thescope for further weakening in the face of another year of low earnings would beseriously constrained. In crude terms, the viability of the action described above reliesupon the achievement of better investment returns in the relatively short-term future.We are at risk of needing to take drastic action if those better returns do not materialise.

As discussed in December, one can look at projected scenarios for 1991 in order to putthose risks into perspective. In broad terms 1991 earnings would need to be:

1.  At around 15% to allow the Society to declare again at 1989 rates and present asimilar level of strength to that at 31 December 1990.
2. At least 8% to enable a declaration to be made at the 1989 level, but showing a weaker position than at 31 December 1990.
3. At least 0% to avoid problems in demonstrating solvency. This would imply no 1991declaration.

Our discussion of the investment outlook in December led to the firm view that anestimated return of 13.6% for 1991 should be used as the basis for the consideration ofbonus and solvency matters. That view then leads to the conclusion that it is appropriateto take the risks inherent in the course of action described above in current conditions.

The Appointed Actuary concludes by saying that he expects to be recommending to the Boardat the following month’s meeting that declared bonuses should be the same as for 1989 andthat final bonuses should be based on a total rate of return of 12% (11.5% for recurrent singlepremium business).

In the disclosed February 1991 paper entitled ‘Valuation and Bonus Declaration at 31December 1990’, the Appointed Actuary provides an update on the valuation and makesrecommendations regarding the bonus declaration.

The disclosed March 1991 ‘Investment Considerations 1991’ Board paper includes a sectionunder the heading of ‘Comparison with our competitors’, in which the Appointed Actuaryreports:

As in previous years, [a named company] and [another company] stand out as taking amore “aggressive” stance than other offices with all, or virtually all, their with profit fundsinvested in equities and properties. Because of that approach, the market conditions of1990 are likely to have resulted in a lower return for them than for offices, such as theSociety, holding a proportion of their assets in fixed interest stock, deposits etc. However,as we have seen from previous analyses, their ability to take this more aggressive stancehas, over longer periods, been to their advantage. No doubt that is a major contributoryfactor to their ability to produce competitive with profits results. Both these offices have a strong balance sheet or “Form 9” position and should have had little difficultyweathering the poor investment conditions of 1990.

Equitable’s Appointed Actuary notes:

The Society does not currently have, nor is likely, given our policy of full distribution, toattain the strength to pursue such an aggressive investment policy as [those companies].We shall, for the foreseeable future, need to continue with a more “balanced” portfolio.A recent survey of theWith Profits Guides of 17 offices indicated that at 31 December1989 the Society’s investment mix was fairly typical of the group as a whole.

Under the heading ‘Implications of and risks associated with the recent bonus decisions’, thereport states:

In putting the Society’s financial position into context at the recent declaration, Iindicated that a return of around 15% would be needed in 1991 in order to “stand still”.That is, to be able to declare again at the same bonus rates at 31 December 1991 andpresent a no weaker position to the DTI than at 31 December 1990. If the 1991 return fell toaround 8% we would begin having problems in maintaining declared bonuses anddemonstrating solvency. In those circumstances the balance sheet position would clearlybe significantly weaker than at the end of 1990.

At the December 1990 Investment Committee, the firm view was expressed that the mostlikely return for 1991 was around 13½%. On that basis, it was agreed that the risksassociated with the declaration decisions were acceptable. It is, however, clear that areturn much below the most likely estimate could lead to an uncomfortable position inthe sense of our published position being sufficiently weak to attract adverse comment,unless most other offices were similarly placed. At some point we could also begin toattract closer scrutiny from the DTI.

Equitable’s Appointed Actuary says:

The signs so far this year are, of course, encouraging. If at some point, however,achievement of a return of the order of 13-14% began to appear in jeopardy, then weshould need to take a serious look at the potential solvency position at the year end.That may lead to the need to increase the yield on the fund rapidly so as to increase therate of interest that can be used to discount the liabilities. For example, it may then benecessary to direct new money towards fixed interest stocks, possibly combined withsome switching of existing holdings. Clearly such action, which may be in conflict withother investment objectives, would only be taken if absolutely necessary.

The weakening of the liability valuation at 31 December 1990 reflected the depressedasset values at that time. As capital values regain a more normal relationship with, say,their 31 December 1989 values, I shall be forced by the regulations to begin strengtheningthe basis again since the liability valuation discount rate is related to the running yield onthe assets. That will imply writing-up of the fund by amounts in excess of those neededmerely to cover new declared bonuses at future declarations. Clearly, the higher theincome yield on the fund in any one year, the greater the room for manoeuvre we shallhave in the liability valuation.

He continues:

The above discussion is essentially concerned with declared bonuses and the solvencyimplications. The position on overall policy proceeds also carries investment implications.These are now considered.

If, in broad terms, we regard the 31 December 1989 position as one of balance betweenpolicy values and asset values, then in 1990 we allocated growth of 12% against actual fund earnings of around -8½%. There is, thus, a shortfall of some 20% for the year to berecovered from future earnings in order to restore a position of balance. If we allocated12% again for 1991 then actual earnings would need to be around 30% to achieve abalanced position again by 31 December 1991. In practice the “recovery” is likely to beachieved over a number of years. It is, however, important to remember where we are.The fact that we have got through the difficulties of 1990, and smoothed a substantialpart of the effects of that for our policyholders, does not mean that we are starting 1991from a neutral base.

The conclusion to be drawn is that the higher the return at market value achieved thisyear and next the more comfortable. A balance, therefore, needs to be struck betweenselecting assets expected to perform well in the short-term and those where the returnswill emerge over longer timescales. That is, the deliberate sacrifice of return in the shorttermneeds to be controlled.

The Appointed Actuary’s report concludes with the following recommendations to the Board:

1. There is no need at the present time for any re-arrangement of the portfolio onactuarial grounds.
2. The level of investment in index-linked securities should continue to be monitoredagainst the growing liabilities under index-linked annuity contracts.
3. In determining strategy, we clearly need to look to maximise overall returns.Whilstcontinuing our usual approach of balancing long and short-term considerations, areasonable degree of emphasis should be placed on producing high returns in the shortterm.That implies, for example, that whilst committing a “normal” proportion of newmoney to assets like property with an initially low, or zero, yield would be consistent withthat view, investing an unusually high proportion in that way would be inconsistent.
4. There need be no specific actuarial constraints on investment strategy at present,beyond that mentioned in (b) above. If at any point there appears a risk of not achievinga return at least of the order of 13-14% there should be an immediate formalreassessment of investment strategy for the remainder of the year. In such circumstancessome actuarial constraints may need to be imposed.
5. If investment considerations are neutral, higher-yielding stocks should be purchased inpreference to lower-yielding, as this will assist the solvency position.

The Directing Actuary, in an undated note to Chief Actuary B, says:

To respect [the Appointed Actuary’s] “preference” I don’t think we need show these to DTIunless the situation in due course warrants it.I will need to review them again before I go to the President’s “appointed actuaries”meeting on 27/9. Please bring them forward on 23/9.

GAD’s Directing Actuary A writes to Chief Actuary B about the issue of the appointment of Equitable’s Chief Executive while remaining Appointed Actuary. The Directing Actuary says that ‘Reading the papers through, I am struck by how this exchange has got out of hand simply by slightly changing the emphasis of certain phrases’. The Directing Actuary points out that the Government Actuary’s statement ‘Bearing in mind the fact that it is not now generally thought desirable for the same person to be [Chief Executive] and [Appointed Actuary] …’ (see 17/04/1991) had been changed by the Chief Actuary to read ‘As it is not now thought desirable for the same person to be both Chief Executive and Appointed Actuary …’ (see 19/04/1991).

Directing Actuary A continues:

What is required is a mechanism to defuse the situation, and especially [DTI’s Line Supervisor A’s] latest note on the Equitable’s letter of 31/5. I have already spoken to [Equitable’s Appointed Actuary] at the Institute seminar on 6/6, not knowing of this correspondence. I told him that provided plans were being put in place to bring along a new actuary in a year or two, I was relaxed (NB [the Appointed Actuary] retires – or is of retiring age – in the not too distant future). He knows our concerns and respects them. However, if someone hasn’t matured as quickly as they had hoped, there is no point DTI getting up-tight. [The Appointed Actuary] now sees this issue as a point of principle for him – and I take his point.

We should explain to [Line Supervisor A] that Equitable is not a one-man show, likely to be dominated by [the Appointed Actuary]. There are several good actuaries in the company, and they are unlikely to fall into the kinds of problems we have seen elsewhere purely because he holds two key posts. DTI should accept the company’s assurances that they will separate the two posts as quickly as it is prudent to do so.

DTI write to Equitable, noting the Society’s:

… current intention to separate the roles of Appointed Actuary and Chief Executivewithin the time frame suggested by [Line Supervisor A]. In the light of that and the pointsmade during our conversation I am happy to confirm our acceptance of [the person’s]appointment without condition.

DTI’s Line Manager A replies to Line Supervisor A’s manuscript note on Equitable’s letter of 31/05/1991. He explains that he had spoken to Equitable the previous evening and that, during that discussion, the Society had again raised objections to the imposition of a condition. The Line Manager says:

If the Appointed Actuary is also the Chief Executive and therefore responsible for taking the decisions on the direction of the company there is, almost by definition, a conflict of interest. The Appointed Actuary is most unlikely to blow the whistle on his own decisions taken as Chief Executive! [Equitable] took the point but said that [they] would still prefer our acceptance to be unconditional. I said we were prepared to lift the condition but nevertheless we noted the company’s intention to find a new Appointed Actuary within 12-18 months and that we would not be constrained from raising the point again at the end of that timescale if no appointment had been made. On that basis I wrote the letter [of 17/06/1991].