Appendix: Summary of Findings

 Case No. C.1597/01  The prudential  regulation of Equitable  Life

The complaint

1. Mr P complained to my predecessor that the  Financial Services Authority (FSA), acting on behalf of the  Treasury, failed to take appropriate regulatory action  which would have ensured that existing and potential  policyholders were able to make fully informed decisions  when purchasing policies or annuities from the Equitable  Life Assurance Society (Equitable). As a result, Equitable  were able to continue to encourage him, and other  investors like him, to purchase a with-profits annuity  without a full understanding of the risks involved. He  contended that, had he been aware of the true position, he  would not have purchased such an annuity in June 2000.  Having purchased the annuity, he was unable to transfer it  to another insurer without penalty. He sought full  redress.

The investigation

 2. The investigation began in December 2001 after  my predecessor had obtained the comments of the  Permanent Secretary at the Treasury. On taking up the  complaint for investigation, my predecessor decided to  limit the period under investigation to that from 1 January  1999, when FSA began to conduct the prudential  regulation of life insurance under contract from the  Treasury, to 8 December 2000, when Equitable closed to  new business. On taking up post in November 2002 I  carried out a careful review of the position and decided  not to depart from my predecessor's decision. I have,  however, of necessity had to look back at some of the  earlier events in some detail to understand the  background to the period under investigation.

Jurisdiction

3. The significant restrictions on my jurisdiction in  this matter are set out in detail in paragraphs 3 to 6 of the  full text of my investigation report (see Part II of this  Volume). I should however emphasise here that FSA fall  within my jurisdiction only in so far as they were acting on  behalf of the Treasury as prudential regulator before  1 December 2001. I have no legal powers to investigate  Equitable, the conduct of business regulators or the  various professional bodies or advisers involved; nor may  I question the merits of a discretionary decision taken  without maladministration.

Evidence

4. During the course of my investigation my  officers examined documents held by FSA, the Treasury,  the Government Actuary's Department (GAD), and the  conduct of business regulators in so far as they related to  the prudential regulation of Equitable. They also  interviewed a number of officers who had been involved  with these events, including then members of FSA, the  Treasury, and GAD. Equitable also submitted some specific  papers requested by my officers. I have also obtained  advice from an independent senior actuary. The detailed  account of the prudential regulators' actions in relation to  Equitable is set out in the chronology of events in Part II  of this Volume; a summary of the officers' evidence is  included in paragraphs 104 to 160 of the investigation  report.

Findings

5. I found that FSA as prudential regulator  constantly had to assess and reassess whether they had  grounds for taking formal regulatory action in respect of  Equitable. As any intervention was likely to have a  significant impact on Equitable's future profitability and  even viability, and could therefore impact adversely on  policyholders and would probably provoke legal challenge,  it was not action to be taken lightly. Furthermore,  Equitable were a long-standing, successful, high-profile  and still growing company; they were highly regarded and  a market leader. Although they were inherently weak  financially, because of their policy of not holding back  substantial free reserves and of distributing as much as  possible to policyholders, Equitable had made no secret of  that policy, which had been a key feature in their publicity  and marketing strategy. The inescapable consequence of  that policy, which they also publicised widely, was that  policyholders would follow the company's fortunes. That  relative ‘weakness’ was not of itself therefore a reason  for intervention, as policyholders were well aware of it.

6. When FSA began to operate as the prudential  regulator on 1 January 1999, there were two key issues  that they had to address: first, the basis upon which  Equitable were reserving for their significant potential  liabilities arising from the guaranteed annuity rate (GAR)  options contained within their individual and group  personal pension plans; and, secondly, the differential  terminal bonus policy used to manage the actual GAR  liabilities arising, and whether that policy met  policyholders' reasonable expectations. Either of those  issues could have provided grounds for the prudential  regulator's intervention.

Regulatory solvency

7. There is no doubt that in late 1998 the Treasury  had briefed FSA in considerable detail about Equitable's  weak regulatory solvency position and had indicated a  possible need for the regulator to intervene if Equitable  either: a) continued to refuse to accept the need to reserve to the level GAD thought appropriate to cover the GAR liabilities, or b) declared a bonus without theregulator's prior agreement. However, that position stoodto be resolved, at least to an extent sufficient to satisfyFSA's requirements in relation to reserving, by areinsurance agreement Equitable were in the process ofnegotiating. By 1 January 1999, when the FSA took over asprudential regulator, the situation had therefore moved onsufficiently for the Treasury's earlier indications of apossible need for immediate intervention to be regardedas no longer valid.

8. Nonetheless, my investigation found that it was  certainly not true to say that FSA knew that Equitable's  position needed to be closely monitored and did nothing.  The prudential regulators could certainly not be criticised  for a lack of concern about Equitable and the position of  their policyholders. There was considerable discussion  about Equitable's situation and about the level of  intervention required - and what could be legally justified -  on the prudential regulator's part. There were also  numerous exchanges and meetings with Equitable as FSA's  prudential division, with GAD's support, tried to ensure  that Equitable secured adequate reserves and did not  worsen their solvency position.

9. FSA continued throughout to insist that Equitable  conform to their full reserving requirements in the face of  strong resistance from Equitable. They also strongly  urged Equitable to be cautious about the bonuses they  paid in 1999 (warning Equitable that they would use their  powers to intervene if Equitable attempted to declare a  bonus before FSA were satisfied that they had sufficient  reserves in place). In March 2000 FSA did not query the  5% annual bonus declared, in contrast to the considerable  wranglings of the previous year, but the bonus payment  was in essence a commercial decision for Equitable (and  fully in line with their publicised policy of maximum  distribution of surpluses). As long as that did not cause  Equitable to breach regulatory solvency (which it did not)  then FSA had no basis for formal intervention on solvency  grounds.

10. There was also the question of whether it was  appropriate in the circumstances for the prudential  regulator to allow Equitable to rely heavily on reinsurance  and on a future profits implicit item (that is taking credit  for anticipated future returns from current business)  effectively to balance their books, given that these might  be regarded simply as technical ways of satisfying the  regulatory solvency requirements which did nothing to  improve Equitable's underlying financial position.

11. Reinsurance was an accepted actuarial practice  in the insurance industry, and GAD confirmed that it could  be used to improve Equitable's regulatory solvency  position. Given that advice, it was reasonable for FSA to  accept the use of reinsurance in Equitable's case. Further  FSA, working closely with GAD, took an active interest in the  terms of the agreement and suggested to Equitable a  number of amendments to the terms to make the  reinsurance as robust as possible and, most importantly, to  ensure that it was subordinate to policyholders'  interests. Although the agreement was only signed some  time after it was deemed to take effect, I received expert  advice that that was not unusual within the industry and  that the reinsurers would have been on risk (i.e. they would  honour the agreement) once the terms had been agreed.

12. From 1994 onwards Equitable used increasingly  larger future profits implicit items in their accounts. I  accept FSA's view that the increase was broadly  proportionate to the growth in Equitable's business and so  did not necessarily point to underlying financial weakness.  I note also that the most significant increase in the sum  applied for was specifically to meet the prudential  regulator's insistence that Equitable reserve fully for their  potential GAR liabilities. Further, the sums sought were  much lower than those for which they had been entitled to  apply under the regulations. That being the case, again I  do not see how the Treasury and their FSA advisers could  reasonably have refused Equitable's applications. I  considered whether a further application made shortly  before the House of Lords' judgment in June 2000 should  have attracted closer scrutiny in September 2000,  particularly as the recommendation to the Treasury was  based on advice to FSA from GAD which appeared to  predate the Lords' judgment. However, I accept the  accounts of GAD and FSA officers that they had  reconfirmed that their earlier advice remained valid, and  that the prudential regulator could not reasonably have  recommended refusal.

Differential terminal bonus policy and policyholders' reasonable expectations

13. Another possible ground for intervention was if  the prudential regulator believed that Equitable were  unable to meet ‘policyholders' reasonable expectations’.  This regulatory concept had no clear legal definition at the  time and was not straightforward. There was no  indication in the relevant legislation as to how companies  were to balance the differing expectations of different  groups of policyholders (for example, those of GAR and  non-GAR, and of existing and new policyholders),  particularly when meeting one group's expectations would  impact adversely on the expectations of others. That  balance was all the more difficult for Equitable, because  they had neither significant uncommitted reserves  (sometimes called free estate) nor shareholders to ask for  more cash.

  14. While FSA recognised that they needed to  address the question of whether Equitable's differential  terminal bonus policy met policyholders' reasonable  expectations, they concluded that there would be little  point in trying to reach a firm view on the matter until the  court had given a final ruling on that policy. (Equitable had  initiated a test case in the courts to determine whether  they had the right to declare differential terminal bonuses  depending on whether the policyholder took up a GAR  annuity option or not.) FSA's decision to await the court's  judgment was undoubtedly influenced by their view, in line  with Treasury guidance of 18 December 1998, that there  were legitimate arguments in support of the differential  terminal bonus policy in certain circumstances. Was that  so misguided a view that it might be considered to bemaladministrative? I do not believe so. I note that the Treasury guidance made clear that the circumstanceswere dependent on the bonus policy having been madeclear in the terms of the contract and on the life insurerconcerned having communicated their policy clearly topolicyholders. FSA took the view that, if that had beendone, there could be no question of policyholders'reasonable expectations not being met. In my view, thatwas a reasonable view to take. Further, given thepotential significance of the anticipated court ruling to thequestion of policyholders' reasonable expectations, and inlight of the other discussions FSA were having withEquitable at the time, I consider that the decision not torush to a firm view in advance of the court ruling was alsoreasonable.

15. The prudential regulator's decision to await thecourt ruling did not however mean that they did notconsider the question of policyholders' reasonableexpectations. FSA wanted to ensure that Equitable'sfinancial position had not previously been, and was notthen being, misrepresented to potential policyholders. Tomeet those concerns they pressed Equitable hard on thereserving issue and asked for early submission of their1998 returns, in which Equitable were required to includespecific reserves reflecting their full potential GARliabilities. The prudential division also referred copies ofEquitable's previous bonus notices, which they thoughtmight be misleading, to the conduct of business regulatorto determine whether they provided grounds forintervention by them.

Should FSA have predicted the House of Lords' judgment?

16. In my view the fact that FSA did not consider theeventual ruling as a strong possibility, either from theoutset or even after the Court of Appeal ruling, did notindicate that they were not carrying out their roleeffectively. The High Court had of course ruled inEquitable's favour, and further, each of the four judgeswho had considered the case up to that point had givendifferent reasons for their conclusions. The Court ofAppeal ruling had underlined that the issue was notclear-cut and had brought to the fore the issue of ring fencingof funds, when one judge commented that in hisview ring-fencing could be legitimate and would limit thefinancial impact of an adverse ruling. FSA did not seriouslyconsider the significant ramifications if ring-fencing werenot permissible until it became clear during the House ofLords' hearing that that ruling was a possibility. However,it would be wrong to say that FSA were totally surprisedby the House of Lords' judgment or ill-prepared for it. Theruling was unexpected, but as it went against muchaccepted actuarial and industry practice, that was not initself a sign of poor judgment; and the possibility hadfeatured in both FSA's and Equitable's scenario planning.The fact that FSA's own legal advisers had raised thequestion of whether ring-fencing could be contrary to GARpolicyholders' reasonable expectations might have alertedthe prudential regulators earlier to there being a realpossibility that the legal view might differ from theactuarial perspective. I do not, however, see that earlierserious consideration of the ring-fencing issue by FSAwould have influenced events in any way.

After the House of Lords' judgment (20 July 2000)

17. Equitable's solvency position (because thejudgment affected the reinsurance agreement) and thedecisions facing the prudential regulator changeddramatically after the House of Lords' judgment. FSA thenhad to decide whether to close Equitable to new businessor to allow them to try to sell the company as a goingconcern. The prudential regulator's primary objective wasto protect existing policyholders' interests by ensuring thatEquitable remained solvent and able to meet theirliabilities. FSA took the view that Equitable's strategy ofseeking a buyer was likely to result in the best outcomefor policyholders. Equitable said, and FSA accepted, that asale could result in Equitable acquiring sufficient fundingto repay the seven months of bonus withheld in responseto the House of Lords' judgment, and possibly to make agoodwill payment to existing policyholders on top of that.That position could only be achieved - if at all - through asale.

18. FSA's decision not to take formal interventionaction at that time, but to allow Equitable to putthemselves up for sale was reasonable as long as therewas a good prospect of success. Equitable said, and FSAand many observers believed, that Equitable would easilyfind a buyer and command a substantial premium. Whilethe regulator was well aware of the financial difficultiesfacing Equitable, I found no evidence to suggest that FSAshould have either considered from the outset that theprospect of a sale was unlikely, or recognised significantlysooner that the sale process would fail. Given initialinterest from bidders and Equitable's reputation, FSA couldnot have justified immediate closure as long as itappeared that the situation was still retrievable. While thepotential liabilities arising from further top-up paymentsinto GAR policies were undoubtedly a significantcomplicating factor, the fact that the three main bidderscontinued in the sales process for some weeks after theybecame aware of that issue strongly supports FSA's viewthat potential top-ups were not in isolation a ‘deal-killer’.FSA's papers indicated that a combination of factorscaused the bidders to withdraw, not all of which related toEquitable's finances; the bidders' own portfolios andbusiness plans all contributed to their decisions.

19. That still left the question, however, of whether  the prudential regulator should have stopped Equitabletaking on new business after the House of Lords' ruling.FSA took the view that maintaining the value of Equitablewas in the best interests of current policyholders, and thatclosing Equitable to new business would damage theSociety's value and probably eliminate the prospect of asale. That view was supported by professional advice Ireceived. FSA saw a need to balance the interests of newand existing policyholders and had decided that thebalance was overwhelmingly in favour of Equitablecontinuing to write new business as all policyholders -new and old - would have benefited from a successfulsale, and Equitable's withholding of seven months'reversionary bonus meant that new policyholders were notbeing asked to subsidise the costs arising from the Houseof Lords' ruling. It was, and remains, the responsibility ofcompanies to make explicit the risks to potential and compensated, under the conduct of business rules, if theysustained losses as a result of joining on the basis ofmisleading information.

20. During the sales process Equitable launched anadvertising campaign which was controversial. I foundthat the prudential regulator decided that, as Equitablewere still meeting all the prudential regulatoryrequirements (and any intervention could have made theposition for policyholders worse by reducing the prospectsfor a successful sale), they had insufficient grounds forformal intervention. They decided instead to bringinformal pressure to bear on Equitable, which they did.That was a discretionary decision on their part which,given the circumstances at the time, I do not consider tohave been unreasonable.

21. Similarly the prudential division took the viewthat they should not require Equitable to put a ‘healthwarning’ on their products. It would not be reasonable toallow Equitable to trade, but then suggest to potentialpolicyholders and annuitants that the company was not agood investment. The prudential regulator had to haveregard to the risks to new investors by requiring acompany to close to new business if it was not, and hadno immediate prospect of becoming, financially sound ormeeting policyholders' reasonable expectations. However,the main concern for new investors would be if theybelieved they had been personally misled as to the stateof the company - and that was a conduct of business,rather than a prudential, matter. In the circumstances, Idid not consider FSA’s decision not to require Equitable tomake such a disclosure to have been maladministrative.

22. That raised the question of whether theprudential division had ensured that they had made theconduct of business regulator sufficiently aware of thefinancial difficulties which Equitable were facing, in orderthat they could reach an informed view as to what actionwould be appropriate on their part. I was satisfied thatwhile, with hindsight, the prudential division might onsome occasions have underlined even more strongly totheir conduct of business colleagues the risks to newpolicyholders and annuitants if no sale was achieved, theprudential division had kept the conduct of businessregulator adequately informed of Equitable's position.

The Treasury's role

23. Although they had contracted out theirprudential regulatory functions to FSA, the Treasuryremained responsible to Parliament for prudentialregulation throughout the period investigated. I wassatisfied that the Treasury had retained sufficient in-houseexpertise in order for them to be able properly to monitorFSA's effectiveness in carrying out these functions to thestandards set in the service level agreement. I was alsosatisfied that, although there was little documentaryevidence of their routine contacts with FSA during thisperiod, the Treasury had kept abreast of the developingEquitable situation and had had regular discussions withFSA about the prudential regulator's position.

Conclusion

24. I have not found any evidence to suggest thatthe prudential regulator failed to take appropriateintervention action during the period under investigation.Nor have I found any evidence to suggest that thedecisions which the prudential regulator made as to whataction (both formal and informal) was required of them inrelation to Equitable, were either outside the bounds ofreasonableness or reached maladministratively. Given thethen regulatory framework, the actuarial advice FSA weregiven, and the legal advice FSA received regarding theproper exercise of their powers, I do not dissent fromtheir view that the prudential regulator could onlyintervene formally if a company breached the statutoryrequirements and that, otherwise, their role was toidentify problems and issues, and through informalpressure, encourage the company to take the necessaryaction to get back to a sound financial base.

25. My investigation has shown that FSA monitoredEquitable to ensure that they did not breach the regulatorysolvency requirements and urged them to take steps toimprove their position. They regularly considered whetherthey had grounds for formal intervention, thought throughthe likely impact of any regulatory action on policyholdersand considered how policyholders' best interests weremost likely to be met. While, with the benefit of hindsight,I have identified in my report several occasions when FSAin their role as prudential regulator might have donethings differently, I have not found that on those occasionsthe action that they did take was in itself unreasonable(nor indeed that those actions influenced the overallcourse of events). I am therefore satisfied that the FSA,acting as prudential regulator on the Treasury's behalf,cannot be said to have acted maladministratively and tohave caused the injustice which the complainant alleges.It follows that I do not uphold the complaint.