Appendix C: Summary of events jan-jun 99

Summary of events: C1597/01

1957 -1998

January - June 1999

July - December 1999

January - June 2000

July 2000 - October 2001

1999

01/01/99

The Treasury's insurance division transferred to FSA and operated subsequently as part of the Insurance and Friendly Societies Division (to whom I shall refer as FSA's prudential division). Their legal advisers transferred to FSA's General Counsel's Division.

04/01/99

GAD told FSA's prudential division that they were reviewing Equitable's mathematical reserves and that three actions were required: first, to tell Equitable they were not satisfied with zero mathematical reserves (paragraph 28) for the GARs in the 1997 returns; secondly, to provide Equitable with a response to Counsel's opinion; and thirdly, to obtain additional information from Equitable about mathematical reserves, resilience, and asset shares, and also the most recent financial condition report produced in accordance with the Faculty and Institute of Actuaries' guidance note. GAD also commented that Counsel had overlooked the key point that prudent assumptions about the proportions of policyholders who might exercise each option ought to depend on the relative values of the benefits, which had increased considerably in the recent past as interest rates fell. Recent take-up rates were irrelevant as additional discretionary cash sums had been paid to those choosing the cash option rather than the GAR, but Equitable did not propose to make provision for future additional cash bonuses. GAD accepted, with hindsight, that they might have questioned rather earlier Equitable's treatment of GARs in the context of the 1993-1996 regulatory returns; however, Equitable had not sought to discuss the question of reserving with GAD or with the Treasury's insurance division, even when it had become a material issue. GAD said that they had not accepted the reserving basis used in the 1997 regulatory returns, and had not had any direct communication with Equitable about them. They agreed that if Equitable were to establish a £1.5bn reserve, it would affect future bonuses, and said that they would consider the question of phasing in the higher reserving requirement in the light of the additional information now being sought.

FSA's legal division told their prudential division that Counsel's opinion provided by Equitable did not cause them to change their view set out in their letter of 07/12/98, and did not even seek to address the regulator's position on the issues. Policyholders could be expected to select the cash commutation only while its value was maintained at close to the value of an annuity taken at the GAR rate. GARs should, therefore, as a matter of prudence be fully reserved. The GAR problem had been revealed only when the Treasury had begun to consider the responses to the GAD survey.

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07/01/99

FSA's prudential division briefed their chairman recommending further draft general industry guidance on reserving for GARs and that FSA's prudential division should require companies whose 1997 regulatory returns did not comply with the new guidance to submit their 1998 returns early. They proposed writing separately to Equitable and attached a draft letter. They said that Equitable had a legitimate expectation that they had until the end of June to present their 1998 return (subject to them not declaring a bonus that would threaten their regulatory solvency). Requiring an accelerated return from them would mean a real risk of a successful judicial review. Action involving a wider group of companies enhanced the possibility of a collective industry challenge. There might be difficult questions about those companies whose 1997 returns were not prepared in accordance with the guidance now being issued and whether FSA would act against them. FSA's prudential division were clear that action to prosecute the companies for supplying improper returns would be a disproportionate response and in any event very unlikely to succeed. [The briefing was copied to the managing director but not to the conduct of business division.]

11/01/99

FSA, following advice from their legal division and GAD, told Equitable that Counsel's opinion had not changed their view of 07/12/98 that GARs must, as a matter of prudence, be fully reserved to within a few percentage points, even though changed economic circumstances had increased significantly the quantum of reserves required. The reality that the discretionary bonuses must continue to be adjusted, if policyholders were to continue to opt for the cash fund, substantially fettered Equitable's discretion not to pay additional bonuses. FSA said that they did not accept that DTI or the Treasury had had notice, as Equitable's Counsel asserted, that the GARs referred to in Equitable's regulatory returns made since 1993 were higher than the current annuity rates. If Equitable considered that the reserving requirement should not be enforced and intervention action not taken, clear and convincing arguments would be needed. Any arrangement falling short of the normal reserving requirement would need to be disclosed in the statutory return.

13/01/99

The Government Actuary issued guidance to all appointed actuaries (reference DAA11) reminding them to make proper provision for all GAR liabilities on prudent assumptions. Reserving requirements would be very similar whether a GAR was the principal benefit or only an option. It was necessary to reserve fully for all alternative benefits offered under the contract. It would not be prudent to assume that policyholders would choose a benefit form of significantly lower nominal value, although an allowance of a few percentage points could be made for other perceived advantages of alternative benefits. Where the terminal bonus was adjusted to bring the value of the GAR option closer to that of the alternative benefits, any reduction in reserves by more than a few percentage points below the full value of the GAR option would need very careful justification by the actuary. The need to hold mathematical reserves to cover GARs should not reduce the stringency of the resilience test to be applied. FSA and GAD would review closely the level of reserves established for GAR options in companies' 1998 regulatory returns.

FSA's prudential division wrote to the managing directors of life insurance companies saying that they had recently asked GAD to circulate to all appointed actuaries guidance on reserving for GARs. Managing directors were asked to review their financial position with their appointed actuary and tell FSA the outcome by 15 February. FSA pointed out that the 1997 regulatory returns for some companies did not conform with the new guidance. Those companies should submit their 1998 returns early, not later than 31/03/99.

The Treasury briefed the then Economic Secretary to note the circular and press notice that FSA were about to issue and to note the scope for criticism from with-profits policyholders who would mostly bear the reserving costs of GARs combined with the liabilities for the costs of pensions mis-selling. FSA's concerns were to ensure that solvency was maintained and that policyholders' reasonable expectations were met. Additionally, the appointed actuaries must have sufficient independence and freedom to discharge their professional responsibilities, including advising the directors on protecting the interests and reasonable expectations of policyholders. In the first instance, FSA should answer any press or policyholder criticisms; the Treasury would only become involved if the adequacy of the regulatory framework or the performance of the regulator were to be called into question.

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14/01/99

FSA issued a press notice saying that they had given all life insurance companies guidance on reserving for GARs and asked them to consider, depending on the information given in their 1997 returns, bringing forward publication of their 1998 returns.

15/01/99

Equitable sought a court declaration that article 65 gave them discretion to allot different amounts of terminal bonus to GAR policyholders when the applicable GARs were higher than the current annuity rates, so as to equalise the total value of benefits taken by any given policyholder.

The PIA Ombudsman began to tell complainants that he had concluded that Equitable had identified an important point of law and, in the circumstances, he should presently cease to consider and investigate complaints relating to Equitable guaranteed annuities by reason of the proceedings to be instituted in the High Court. He would keep the progress of the litigation under review.

18/01/99

An internal FSA minute from the head of advertising supervision to the head of conduct of business said that he was concerned that FSA had issued guidance (the prudential division's guidance to insurance companies on GARs of 13/01/99) representing the position of one part of FSA, when other parts of FSA had not had the opportunity to consider the matter properly. He said that that was particularly relevant when, as on this occasion, the conduct of business division's position might differ from that of the prudential division. Given the size of the GAR problem, the conduct of business division felt obliged to look closely and check whether any of the activity of the life insurers fell within their jurisdiction. They might decide that insurers had not done anything since 1988 which would fall under PIA's selling and marketing jurisdiction; on the other hand they might find something which they would feel obliged to pursue as part of their general brief to protect investors. Their instinct was to find out how the guarantees had been promoted to investors and, if appropriate, to require firms to honour their promises. The approach of FSA's prudential division was to preserve the financial soundness of companies by agreeing that bonus rates to GAR policyholders could be reduced, creating a clear conflict between conduct of business regulation and prudential supervision. The press notice reference to protecting policyholders had been a bit unfortunate. The author of the note said that he would hate to have to explain to a policyholder how they were protecting him or her by agreeing that the insurer could pay a pension substantially less than expected. He presumed that there was some mechanism within FSA to co-ordinate regulatory activity and asked if they should be noting their interest at a higher level.

Prompted by GAD, FSA's prudential division asked Equitable for further information about their reserves, assets and financial condition.

20/01/99

In an internal note, FSA's prudential division said that Equitable had said that they would reply to them on bonuses and financial reinsurance within a day or two. Equitable expected the court case to be taken in late September, but an appeal could push it into the next year.

The conduct of business division circulated a note considering what their involvement should be in relation to guaranteed annuities. They noted that policies sold before 29/04/88 were probably outside jurisdiction. However, given the media attention, it seemed sensible to consider in more detail the issues raised by Equitable's treatment of GAR options to see if there was action that they should be taking to fulfil their regulatory obligations. Apart from any new sales after that date, top-ups of existing contracts or switching policyholders out of policies with GAR options might have generated documents providing information to policyholders about regulated products. Concern remained about the potential for conflict between the obligations of FSA's conduct of business and prudential divisions. The prudential division had interpreted the requirement for a company to meet policyholders' reasonable expectations to mean that GAR policyholders could reasonably expect to pay something for the benefit of the GAR. The conduct of business approach was to find out how guarantees had been promoted and, if appropriate, to require firms to honour their promises. There might thus be a clear conflict between the obligations of conduct of business regulation and prudential supervision.

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21/01/99

Equitable replied to the prudential division's letter of 18/01/99 promising the data in a few days. They said that they planned to declare a 5% bonus for 1998, down from 6.5% for 1997. Equitable continued: "as you are aware, we have entered into a financial reassurance arrangement with effect from 31 December 1998, as you helpfully suggested in your letter of 7 December 1998" [Treasury's insurance division had then agreed to accept reinsurance] with the aim of enabling Equitable to reserve at a level they felt prudently reflected their likely future experience. The appointed actuary would take up the matter direct with GAD to confirm that this would have the intended reserving effect. The reinsurance was a financing arrangement which would provide support to Equitable when more than 25% by value of the GAR business maturing in that year selected the GAR option. The cost was to be £150,000 per annum.

FSA's prudential division briefed the FSA Board on issues facing the insurance regulator, including the spiralling cost to the industry of meeting annuity guarantees. The Board noted that the Treasury remained responsible for prudential regulation until the Financial Services and Markets Act was implemented in full [01/12/01] (paragraph 6) and that any major change in policy would need to be agreed with them.

22/01/99

Equitable's appointed actuary told their Board that the lowest assumption as to the proportions of benefits taken as GARs that would not contravene GAD guidance was between 65% and 80%. Fewer than 1% of relevant clients had exercised GARs in 1998. In the absence of regulatory pressure, a suitably prudent assumption would be for 25% of benefits to be taken as GARs. He added that that was also the level of reserving the reinsurance arrangements being negotiated were intended to facilitate. He recommended a declared bonus for 1998 to be based on a return of 5%.

FSA's prudential division said in a briefing that Equitable was one of four companies giving cause for concern, principally due to GAR options. It was questionable whether Equitable would be able to declare a bonus. Equitable had agreed to discuss with FSA in advance any proposed bonus declaration. Based on GAD guidance, Equitable appeared to be just solvent with £1.15bn available assets covering a regulatory solvency margin of just under £1bn. They had sought and received an increased future profits implicit item of £1.9bn and were exploring the possibility of reinsurance for their GAR liabilities. Not to declare or to limit the annual bonus and to publish a low solvency position in April would be commercially damaging; their survival as an independent entity could be threatened. Should the court case go against Equitable their financial position could become even more precarious, and they might become liable to enhance past settled claims.

25/01/99

PIA published revised rules and explanatory guidance on the rates of investment return and mortality assumptions to be used for projections of future benefits under life and pensions policies.

26/01/99

Equitable provided the additional financial information that FSA's prudential division had sought on 18/01/99.

FSA's prudential division asked Equitable for copies of papers relating to any bonus recommendations made to the Board within the previous 12 months and to the valuation by the appointed actuary at the end of 1997.

FSA's legal division told the prudential division, in the context of a draft reply to a Member's request for a copy of FSA's guidance, that any FSA decision on policyholders' reasonable expectations might be viewed by the courts as unfair if policyholders were not formally invited to make submissions to FSA on the matter. They also said that it would be helpful to see the papers relating to Equitable's court case. (FSA's prudential division did not request those papers from Equitable until June 1999.)

FSA's prudential division told their legal division of their strong preference not to reach a decision on policyholders' reasonable expectations until after the court case. The court decision would not preclude FSA from taking a view on intervention, but the judgment of whether or not policyholders' reasonable expectations had been met would depend crucially on the precise nature of the individual contracts, so that it would be sensible to await the court's decision on the legal position.

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27/01/99

GAD commented to FSA's prudential division (copied to the legal division) on the financial reinsurance arrangement which Equitable were proposing. They said that they had no details about the financial strength of the reinsurer or what support, if any, the reinsurer's parent company might guarantee them. They said that the reinsurance treaty provided support to Equitable in any year when more than 25% (by value) of the guaranteed business vesting in that year chose the GAR option. It limited the reinsurer's overall exposure at any time to £100m. If claims were raised, Equitable would create a debt in their balance sheet and repay a recovery amount each year until the debt was fully repaid. The cost to Equitable was £150,000 per annum. Either party could cancel the treaty retroactively to the previous 31 December if certain contractual events occurred. The treaty could also be cancelled if Equitable changed their practice on GAR options which, GAD presumed, would include Equitable losing their court case.

At a meeting of the Tripartite Standing Committee (paragraph 37) FSA reported the dispute with Equitable about their reserving policy and the proposed bonus payments. They said that there were a number of options for handling this, including the possibility of reinsuring some liabilities, or limiting the bonus paid. It was agreed that FSA would continue discussions and report back to the next meeting.

28/01/99

GAD and FSA's prudential division met with Equitable to discuss the draft reinsurance agreement. According to FSA's note of the meeting, there were a number of issues of concern in relation to the drafting of the treaty, though it was considered that the treaty was capable of being revised so as to address each one. First, was the way in which the liability to the reinsurer was defined. Secondly, Equitable were unclear as to why it had been proposed that it should be possible for the reinsurer to cancel the treaty retroactively, and agreed that that would not be appropriate. Equitable agreed also to look to reduce the circumstances under which the treaty could be cancelled. Thirdly, there was a concern that reaching the £100m limit would trigger cancellation. Equitable said that that was not the intention, it was intended only to provide a right to review the terms of the treaty. If no agreement could be reached on revising the terms, the treaty would continue unamended. Equitable would look at redrafting the provision so that that was clearer. GAD emphasised that repayment of outstanding reinsurance claims should be subordinated to policyholder claims. Equitable asked how the reinsurance might be presented in the annual returns; they preferred not to show a reserve of more than £1bn for GAR options as they believed that that would be seen as indicating the real cost of those options to the company. FSA emphasised that their main concern was that the reserving basis should be clear from the returns. GAD had not yet determined the implications of the reinsurance treaty for the level of the future profits implicit item for which Equitable could take credit in their returns. Equitable said that they expected to use only the £850m originally applied for. They said that they expected to agree the revisions to the treaty during the following week and would supply GAD/FSA with the updated version. Following GAD's query of 27/01/99, the question was also raised as to whether Equitable were satisfied that the reinsurer was financially strong enough to fulfil the potential obligations under the treaty (to cover a potential £1bn+ liability). In response Equitable highlighted the reinsurer's AAA rating which GAD subsequently confirmed.

29/01/99

GAD told FSA's prudential division that they had been provided with copies of relevant Board papers relating to Equitable's proposed bonus declaration. They said that the papers showed that Equitable were sensibly seeking to balance a progressive reduction in the additional guaranteed benefits each year with a reasonably competitive position and smoothing bonus declarations in line with the perceived expectations of policyholders. The cost of the declared bonus for 1998 would be some £365m; assuming that the reinsurance was completed, and that it was accepted by FSA as allowing a significant reduction in the reserves, Equitable would, based on their draft 1998 returns, cover their solvency margin by 250%, a similar level to that shown for 1997. Without the reinsurance, cover would be only 110%, though Equitable would then be able to take credit for a larger future profits implicit item. The financial position shown was likely, therefore, to appear reasonably satisfactory, though they would be potentially close to regulatory action for failure to maintain the required minimum margin if the reinsurance were not completed satisfactorily. It would be difficult to object formally to what Equitable were proposing though their position would need to be monitored carefully. They went on to say that the current reserving standard was not unreasonably harsh, with the possible exception of the resilience reserve requirement on GAR policies, which would be dealt with by the proposed reinsurance. When telling Equitable that they would not object to the proposed rate of bonus, GAD and FSA's prudential division should voice their concerns about Equitable's vulnerability and ask them to produce some contingency plans on how they would react to adverse investment conditions. GAD also noted that Equitable continued to issue annual notices to policyholders showing a high level of projected benefits and thereby generating further expectations.

GAD telephoned Equitable to discuss the valuation basis underlying a valuation result in an Equitable Board paper. GAD told Equitable that further discussion would be needed before FSA's prudential division would be able to accept that certain adjustments that Equitable were proposing to make to their valuations basis would produce acceptably prudent reserves. The discussion revealed that Equitable had included an allowance of £450m for future top-ups in their reserve calculation.

In a note of that call, GAD commented that Equitable now seemed to be accepting the ultimate need for full provisions, but appeared to be hoping to phase them in, and had suggested that the Treasury had given that idea a favourable mention at an earlier meeting. No further progress had been made on the draft reinsurance treaty, but Equitable saw no major problems arising and hoped to reach final agreement the next week.

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01/02/99

FSA's prudential division wrote to Equitable, saying that it was important that they resolve the points of concern around the reinsurance treaty since, in the absence of a robust reinsurance agreement, it would not be prudent to declare any bonus for 1998. Without reinsurance, solvency margin cover would appear so low as to be easily eliminated by a small move in market conditions. If allowance was made for the proposed reinsurance treaty Equitable's financial position appeared significantly stronger, although even then Equitable would need to consider carefully the scope for declaring a bonus, given the uncertainties surrounding the financial implications of losing the court case. They should also take into account their heavy dependence on the reinsurance for solvency cover, and the risk of its being cancelled by the reinsurer by reason of losing the court case or for some other reason. FSA said that those were matters of judgment for Equitable in the first instance but, on the basis of the information provided, and assuming that the treaty were revised to resolve GAD's concerns, they were not minded to object to the proposed bonus declaration. They asked to be kept informed of progress on revising the terms of the reinsurance before reaching a final view on the proposed bonus declaration. FSA concluded that Equitable should not take FSA's decision not to intervene over the bonus declaration as an endorsement of what Equitable were proposing and added that they remained concerned about Equitable's ongoing financial health. They asked for revenue and solvency projections and contingency plans.

03/02/99

Equitable told FSA's prudential division that discussions with the reinsurers were proceeding and that they hoped soon to be able to provide a revised version of the treaty. They said that they had already considered their position in the unlikely event of losing the court case, and that they would be discussing that with their Board.

12/02/99

Equitable sent FSA's prudential division a copy of the draft reinsurance terms, saying that amendments had been negotiated to reflect the points made by FSA at the meeting on 28/01/99. They said that there now seemed to be no impediment to their proceeding with the planned bonus declaration.

Equitable sent a further letter in reply to FSA's letter DAA11 of 13/01/99 to all life assurance companies about reserving for GARs. Equitable said that their 1997 regulatory returns did not comply with the new guidance and that to achieve that, they would have had to use the full £700m future profits implicit item rather than the £371m that they had used in the submitted returns, to achieve the same result. The solvency margin would then have declined from 2.5 times to 2.0 times, but this would still have been consistent with the ratios that had given them an AA financial strength rating for the last five years. The reinsurance coupled with the full use of the £850m future profits implicit item would restore the margin to the level in the returns as submitted. In light of that, Equitable said, they saw no necessity for their 1998 returns to be submitted earlier than normal. 

The managing director told the FSA Board that further consideration had been given to the position of those life companies affected by GARs and pensions mis-selling. FSA's prudential division were giving particular attention to the case of Equitable, who normally declared their annual bonus in February.

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16/02/99

FSA's prudential division told Equitable they still had one concern with the revised draft reinsurance agreement relating to the provision for settlement of claims. They wanted to see that issue resolved before Equitable declared a bonus, and they offered a further meeting later that week.

18/02/99

GAD told the prudential division that the revisions which Equitable had now faxed to them had not addressed all the points in their letter of 16/02/99.

The prudential division replied confirming that a meeting had been arranged with Equitable the next day to discuss and agree in principle the proposed reinsurance treaty. They said that they hoped that "we only ask for further changes [to the reinsurance terms] if absolutely necessary, especially as we have already made requests that go further than what we had indicated we wanted in earlier discussions".

GAD agreed that they should keep to a minimum any request for further changes to the terms, but added that they should be very careful about giving firm agreement to the full effect of the treaty without seeing the final wording.

19/02/99

In his weekly report to the managing director, the director said that Equitable's bonus declaration was still subject to satisfactory reinsurance arrangements being put in place. If FSA were satisfied that the reinsurance was effective, Equitable were likely to approve a 5% bonus on pensions business - a drop of 1.5%, and at the low end of industry declarations, but better than had at one stage seemed possible.

22/02/99

FSA's prudential division told Equitable that their position remained unchanged: subject to the reinsurance treaty having the effect of allowing an appropriate offset to be made, FSA's prudential division were not minded to object to Equitable's proposed bonus declaration. However, they would still expect the points they had made to Equitable in their letter of 01/02/99 to be taken into consideration when deciding the scope for declaring a bonus.

GAD wrote to Equitable setting out the points covered in their discussion of 19/02/99. GAD confirmed that they accepted the principle of the reinsurance treaty allowing an offset if 25% of policyholders took benefits in GAR form, but said that they still needed to see the final version of it.

23/02/99

The court ordered that a named policyholder (Mr Hyman) should represent the interests of all policyholders in the matter of GARs, but said that that did not preclude a policyholder from seeking relief based on allegations about the way policies had been sold, if those allegations were based on facts not before the court.

24/02/99

FSA's prudential division told Equitable that their 1997 regulatory returns might have given potential policyholders a misleading impression about Equitable's financial position. They recognised that Equitable had taken action to address the situation but said that that had not strengthened the company's financial position to a point where it was as strong as had been presented in the 1997 returns. Equitable would have to rely on a much larger future profits implicit item in the 1998 returns, even with the reinsurance agreement, to achieve the same apparent solvency margin cover. Equitable were asked to agree by 3 March to submit the 1998 returns by 31 March 1999 or face possible regulatory action.

FSA reported to the Tripartite Standing Committee that they were still discussing Equitable's plans for reinsurance of some of the risks. If those plans were approved, then Equitable would pay a 5% bonus, which was at the lower end of market expectations.

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26/02/99

The FSA director told the managing director in a weekly report that Equitable had now arranged satisfactory reinsurance which had cleared the way for them to announce a 5% bonus on most policies. They had also been invited to accelerate submission of their regulatory returns to the end of March.

Equitable agreed to submit early the 1998 regulatory returns.

03/99

Equitable rejected an approach made by another mutual life company for the companies to merge and then demutualise.

The FIA issued a position statement on annuity guarantees to enable its Officers, Council members and senior members of staff to respond to questions from the actuarial profession, members of the public and press. [The statement, which was placed on the profession's web site, was not formal guidance and said that it should not necessarily be taken as a full expression of the profession's views on the subject.] The statement said that the precise position of insurers in relation to their annuity guarantees would vary substantially depending on the exact wording of policy terms and conditions, references made in marketing literature and other representations made by the insurer on the subject. Companies needed to consider their individual position, and also to consider the reserves required in order to meet their policyholders' reasonable expectations. The Treasury's letter of 18 December 1998 demonstrated that there was considerable variation in how policyholders' reasonable expectations might be interpreted but individual offices might be constrained in different ways. The profession fully supported the regulator's position as set out in that letter. The Appointed Actuary of each insurer had a duty to ensure that sufficient reserves were held to meet that insurer's obligations under its own approach.

02/03/99

FSA's prudential division told their chairman that Equitable had volunteered to submit their 1998 returns early, but did not wish this to be divulged ahead of publication. Responses to the January guidance indicated that companies were now reserving for guaranteed annuities to a common minimum standard, which was an important safeguard for policyholders.

03/03/99

A firm of solicitors then acting for Equitable (Equitable's then solicitors) asked FSA's prudential division to confirm that the Treasury would consent to a proposed supplement to the subordinated loan agreement and to any consequent modifications to the section 68 order of 19/08/97.

05/03/99

FSA's prudential division asked GAD for advice on Equitable's request of 03/03/99.

10/03/99

The first quarterly meeting between the Treasury and FSA's prudential division took place. FSA explained that there might be a problem with the way in which some companies were reserving for GARs; they said that they would need to monitor those companies and request early returns. No specific reference to Equitable was recorded.

18/03/99

The managing director told the FSA Board that FSA had been reviewing companies' exposure to GARs. He said that after setting aside reserves consistent with [FSA's] guidance, Equitable's free assets were so low that the prudence of paying a bonus that year had been questionable. Equitable had now put in place a reinsurance treaty to cover the additional reserving liability and would declare a reduced bonus of 5% (which he said was at the lower end of the industry range for 1999). They had also agreed to submit their regulatory returns early.

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19/03/99

In an internal memo FSA's prudential division summarised the position of the six companies identified as being potentially at risk from GAR options and whose statutory solvency could be threatened if economic conditions were to deteriorate. Of those six, Equitable was viewed as giving rise to the greatest concern. A second group of five companies was said to be of less concern because, although each had substantial exposure to GAR options, all had, or were acquiring, well capitalised parent companies. They said that Equitable's financial position had been very severely affected. A reserve of £2.9bn would be required at the end of 1998. After establishing that level of reserving, and allowing for significantly reduced levels of bonus, they would only just be able to cover their regulatory solvency margin. Equitable were seeking to finalise a reinsurance agreement which would reduce the reserving requirement by some £2bn, thereby increasing the solvency margin to a more acceptable level. However, they remained concerned about the viability of Equitable in the longer term. Equitable had declared high levels of guaranteed bonus in the past and their ability to honour those guaranteed bonuses appeared to be heavily dependent on their continuing to achieve high investment returns. Their liabilities for GAR options could also increase significantly if gilt yields fell further. Equitable had agreed to provide financial projections for their business over the following three years, which would enable the prudential division to make a more accurate assessment of the longer-term position. However, if Equitable were to lose the court case they could also incur significant compensation costs.

24/03/99

Responding to a proposal by FSA's prudential division to seek information from two insurance companies about proposed changes to their terminal bonus practices, GAD said that they saw a serious danger in picking on a few companies, perhaps with worse financial positions than average, and pressuring them to adopt a more generous line, while less threatened companies continued to operate the same practices without question. They suggested a new survey of practices covering all companies with any GAR exposure, since much had changed since their 1998 survey.

The prudential division replied to GAD that their proposal had arisen from concerns that their approach to the two companies in question was not consistent with their approach towards Equitable (and one other). They had asked Equitable (and that other company) to say how their approach was compatible with policyholders' reasonable expectations, and believed that they should do the same for any other company whose bonus practice gave rise to similar concerns (which they believed to be the case here). They went on to say that, due to resource implications, their practice had been to seek information about differential bonus practices and their compatibility with policyholders' reasonable expectations only where it had been brought to their attention that such a practice was being adopted. They had not wanted to "go looking for trouble", but had thought that they needed to be seen to do something where the issue had been raised. They accepted, however, that there was a case for a more systematic approach. They concluded that they did not have the resources to look at large numbers of documents from different companies to determine whether they met policyholders' reasonable expectations. However, they might cope with a more limited exercise whereby they asked companies to explain how their approach was consistent with policyholders' reasonable expectations, and then assessed the reasonableness of their replies. They asked whether GAD were suggesting that they should undertake such an exercise.

GAD replied that they believed that most companies were awaiting the outcome of Equitable's court case, and that a further survey would probably be needed after the case had been resolved.

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30/03/99

Equitable submitted their 1998 regulatory returns, which disclosed the reinsurance agreement (but did not say that it was contingent upon there being no change to Equitable's differential terminal bonus policy). In the returns Equitable assumed between 70% and 82.5% of eligible policyholders would take the GAR option.

GAD told FSA's prudential division that there was no good reason for the Treasury to object to the request of 03/03/99 from Equitable's solicitors for a proposed supplement to the subordinated loan agreement. They said that the revised position was adequately covered by the existing section 68 order [and therefore there was no need to put the matter to the Treasury].

FSA immediately passed that information on to Equitable's solicitors.

Equitable applied to FSA's prudential division for a section 68 order to allow a future profits implicit item of £1bn to be used towards their required solvency margin on 31/12/99; they said that the sum applied for took account of the reinsurance arrangements. They added that they had included a future profits implicit item of £850m in their 1998 returns.

FSA's prudential division asked Equitable, in the light of falling interest rates, to provide by 30/04/99 an update on their latest estimate of the costs of the expected liabilities arising from the personal pensions review. They also reminded Equitable of their continuing responsibility to tell them immediately if Equitable's regulatory solvency margin was likely to be breached or if policyholders' reasonable expectations could not be met.

31/03/99

The prudential division initially recorded Equitable's 1998 regulatory returns as priority rating 3. [FSA have since explained that this was the rating given in the prior year. Following initial and detailed scrutiny, GAD assigned Equitable's regulatory returns a priority rating 2 in May 1999 - which meant that they would be subject to a priority 2 ranking scrutiny in the following year.]

01/04/99

Equitable sent the reinsurer a letter of understanding, not intended to be legally binding, to clarify the intentions of the parties to the reinsurance treaty "incepting 31 December 1998". The letter said that if the withheld fund exceeded £100m, and no solution could be found under the Agreement terms, then the treaty would be cancelled. Equitable would not request a cash payment from the reinsurer for any item unless it was essential to satisfy regulatory requirements. The intention of the treaty was to create flexibility for Equitable in their reserving. [Equitable faxed this letter to FSA on 24/09/01; FSA told my investigators that neither they nor the new management of Equitable had previously been aware of the letter. FSA issued a press release to that effect on 26/11/01 and launched an investigation into why they had not received a side copy of the letter in April 1999.]

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09/04/99

GAD reported to FSA's prudential division the results of their initial scrutiny of Equitable's 1998 regulatory returns, saying that the financial position appeared satisfactory. Equitable were covering their solvency margin by a factor of 2.5, which would be reduced to 1.66 without the future profits implicit item. They had made allowance for non take-up of GARs to a greater extent than GAD had considered appropriate in the light of the Government Actuary's guidance. However, the solvency implications were negligible, as the reinsurance treaty should largely cancel out any increase in the provision that would be required by raising the assumed take-up rate. GAD said that they could only presume that Equitable had been reluctant to disclose any higher figures for their gross liability, or the extent of their consequent reliance on the reinsurance. GAD added that they had not yet seen a copy of the finalised reinsurance treaty and they asked FSA's prudential division to request it urgently. They said that they aimed to complete a combined detailed scrutiny of the 1997 and 1998 returns by the end of June. [This was consistent with priority rating 2.]

15/04/99

FSA's prudential division asked Equitable for a copy of the completed reinsurance agreement. They repeated their request of 01/02/99 for revenue and solvency projections and contingency plans.

20/04/99

Equitable told FSA's prudential division that they were still waiting for the finalised treaty from the reinsurer but enclosed a copy of the terms sheet, on which they said the treaty would be based. They said that that was as discussed with GAD in February, except for one point which had been amended in line with GAD's advice. The solvency projections requested on 01/02/99 were not yet available due to the additional work that had been occasioned by the early submission of the regulatory return. They expected to make those projections available to the prudential division by the end of the month. (The terms sheet showed that the reinsurance was contingent on no change being made to Equitable's then current GAR practice, either by choice or as a result of legal action; and that if the withheld claims balance exceeded £100m, the treaty would be "restructured". No mention was made of cancellation).

Equitable also enclosed a copy of a paper, prepared for their Board by their appointed actuary, on the measures open to the company to protect their statutory solvency position. One issue that the paper discussed was how Equitable might use policy conditions to restrict growth in GAR business and prevent policyholders from making top-up payments to existing policies. It said that if in any policy year no premium was paid, the terms on which future premiums would be accepted would be at Equitable's discretion. That meant that in any year when no premium was paid, they could, in theory, withhold in respect of future premiums any guarantee applying under the policy. The disadvantages to such an approach, however, were that: having traded on the flexibility of their products, Equitable could then be seen as penalising customers who sought to take advantage of it; they would need to give policyholders warning of their intentions, and of the rights that they stood to lose; and policyholders might then make minimal payments to maintain their rights to the guarantees, which would negate much of the benefit that Equitable might hope to gain. The paper concluded with a list of measures which it was said it would seem sensible to pursue. These included: taking on further subordinated debt; using reinsurance (to capitalise future profits through a financial reinsurance agreement); shifting the equity portfolio to higher yielding stocks; actively encouraging policyholders to give up their GARs; and gradually introducing new products with no entitlement to declared bonuses.

21/04/99

FSA's prudential division copied Equitable's letter, with enclosures, to GAD. They asked GAD whether it was appropriate for Equitable to take credit for the reinsurance treaty in their 1998 regulatory returns if the treaty had not yet been finalised.

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27/04/99

GAD commented to FSA's prudential division on the measures which Equitable had put forward in the Board paper [see 20/04/99 entry]. They said that the measures looked "fairly plausible", but could ultimately reduce investment returns (which they said the paper clearly recognised), and one of the options discussed ("threatening" lower annual rates of return to GAR holders - with the option of giving up the GAR in exchange for higher bonuses) might conflict with product and marketing literature. They said that FSA had already agreed in principle to reinsurance and had told Equitable that where there was a letter of intent in place at the valuation date, credit could be taken for the existence of a reinsurance agreement. Commenting on the changes that had been made to the treaty, they said that they were content with the level to which adjustment premiums (that is Equitable's obligation to repay in the future any sums paid out under the treaty) were subordinated to policyholders' rights. They noted that the premium payable by Equitable had increased from £150,000 to £400,000.

29/04/99

Equitable sent their 1998 Companies Act [statutory] report and accounts to FSA's prudential division.

In an internal memo FSA's conduct of business division noted that they had visited the PIA Ombudsman to discuss complaints received about guaranteed annuities, particularly concerning Equitable; the division had also been liaising with FSA's prudential division on the issue. They understood that most of the complaints in question had been about policies sold before 1988, so there was little action that they could take. They noted that there was a possible conflict between the respective positions the FSA was required to take in respect of prudential supervision and conduct of business regulation. They concluded that, in view of the court case, there was little to be done at that time from a supervision angle.

30/04/99

Equitable wrote to the then Economic Secretary protesting that FSA's approach to reserving for guaranteed annuities bore little resemblance to commercial reality and was likely to lead to lower benefits for policyholders. Equitable said that the regulatory guidance on reserving for policies containing GAR options was extremely onerous. While they had estimated the cost of meeting the guarantees at £50m, and with the agreement of their auditors had included a prudent provision of £200m in their accounts, thereby allowing for a significant deterioration in future financial conditions, to comply with the terms of the guidance they would have to set up an additional reserve of £1.6bn. They said that the modest cost of the reinsurance, and the acceptance by their auditors of their provision of £200m, were evidence of the excessively prudent nature of the reserving requirements. Equitable complained about the likely effect on the industry of the reserving requirement, believing that FSA and GAD had limited room for manoeuvre, and said that Ministerial intervention might secure a more commercial and satisfactory outcome.

04/05/99

Equitable sent FSA's prudential division the projected solvency information requested on 01/02/99; FSA's prudential division passed it to GAD for comment. The projections were made on the basis of three different scenarios, each making different assumptions as to the state of the investment market. The projections showed Equitable remaining solvent under each of the three scenarios. Equitable said that the projections assumed declared bonus rates at ½% lower than for 1998, and that in the least favourable of the three scenarios, bonus levels could be lower still. Long term projections to 2003 showed the solvency position improving steadily under each of the three scenarios. Equitable said that assuming investment conditions similar to those prevailing at 31/12/98, they estimated the commercial cost arising from GARs at £50m, though experience showed the actual cost to be lower. Estimating that cost in respect of the scenarios used for their solvency projections, they said that under the least favourable scenario the cost would rise to £500m, while at the other extreme it would disappear altogether.

Equitable had also attempted to project the impact of losing the court case, but that was difficult to do as there were a number of components, any one of which could have an impact on solvency. Taking what they described as a less favourable (but not the worst possible) outcome, they said that, if that were coupled with the least favourable of the scenarios used for the solvency projections, the position would become unacceptably tight. (A manuscript note by FSA's prudential division commented "why wasn't this scenario demonstrated?") In summary, Equitable said, they remained statutorily solvent in a number of scenarios; the long term projections showed an improving regulatory solvency position; and the shorter term position was capable of being strengthened. The key solvency consideration of an unfavourable outcome from the court case was replacement or modification of the reassurance arrangement, which they said was being actively pursued.

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05/05/99

Following policyholder complaints, FSA's prudential division agreed with the conduct of business division to be responsible for handling queries relating to GARs and the acceptability of insurers cutting terminal bonuses to policyholders exercising a GAR option. This was on the grounds that this was largely an issue of policyholders' reasonable expectations.

11/05/99

The second quarterly meeting between the Treasury and FSA's prudential division took place. According to the minutes, GARs were not discussed, although the Treasury did ask FSA's prudential division to provide a contribution to a reply to a policyholder's letter of complaint about Equitable.

18/05/99

The Treasury asked FSA's prudential division for advice on Equitable's letter of 30/04/99 to the then Economic Secretary. They said that the Economic Secretary had found odd, and if true disturbing, the requirement for Equitable to set up an additional reserve of £1.6bn.

20/05/99

GAD gave FSA's prudential division a detailed scrutiny report on Equitable's 1997 and 1998 regulatory returns; the priority rating given to Equitable was 2. [FSA told my staff that detailed scrutiny of the 1997 returns had been held over to be completed alongside detailed scrutiny of the 1998 returns, which Equitable had been required to submit early - by 31/03/99. This meant that the detailed scrutiny of the 1998 returns was available much earlier than it would normally have been.] GAD said that as a result of current market conditions GARs were proving extremely onerous, although Equitable were attempting to restrict the ultimate value to policyholders exercising those options to their appropriate accumulated asset share. In reserving for those liabilities, Equitable had made assumptions as to the number of policyholders who would opt to exercise the guarantees which stretched the concessions offered in the 13/01/99 guidance letter (DAA11); a policy decision was therefore needed as to whether to challenge Equitable's reserving assumptions for the guaranteed annuities. FSA and GAD also needed to consider the final terms of the reinsurance agreement. GAD said that losing the court case would result in Equitable having to reduce the terminal bonus additions for a wider group of policyholders, possibly all of them. Section 68 orders for future profits implicit items had risen from £700m (£371m used) on 14/10/97 to £1,900m (£850m used) at 30/12/98. The total current asset shares, which had been indicated to members as their policy values, exceeded total current admissible assets.

GAD went on to say that a large proportion of Equitable's business was written on a participating basis, so that, provided the currently high level of annual emerging surplus continued, Equitable should be able to work their way out of their solvency margin problems. They considered it highly desirable, however, in view of the risks posed by the possibility of a downturn in asset values, that Equitable should hold back more emerging surplus by declaring lower guaranteed bonuses, though they could still pay out appropriate final benefits by way of non-guaranteed bonuses. It would seem desirable that policyholders should be given some greater warning about the possible implications for future bonuses of a substantial market setback.

21/05/99

In an internal note, which appears to refer to Equitable's solvency projections of 04/05/99, GAD suggested further plausible scenarios which Equitable should be asked to consider. They added that Equitable should also be asked to confirm that they had allowed for the cost of the bonus as at 31/12/99, and that the estimated reserves at that date had been calculated on a basis comparable with that used for the previous year.

FSA's prudential division provided the Treasury with a briefing note addressing the concerns that the then Economic Secretary had expressed following Equitable's approach to her. They said that they did not consider the size of the reserve that they were requiring Equitable to set up for GAR options to be disproportionate to the risk the company was carrying. An attached note explained that the reserving standards applied in Treasury returns were invariably more onerous than general accounting standards, requiring a level of reserve sufficient to meet all reasonably foreseeable circumstances. In Equitable's case the difference between the two (£1.4bn) was larger than normal because Equitable were effectively making an assumption in their accounts that equity prices would continue to rise. While that may be acceptable in company accounts, it was not considered prudent for statutory reserving. Further, the approach taken by GAD towards reserving for GAR options had been widely endorsed within the actuarial profession.

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24/05/99

FSA's prudential division passed on extracts of the GAD scrutiny (20/05/99) to their head of division saying that they would have to challenge the GAR reserving assumptions as making allowance for cash commutation was contrary to specific guidance from the Government Actuary and a reserving level of 70% seemed unacceptably low.

25/05/99

FSA's conduct of business division received a letter from the Consumers' Association (dated 21/05/99) expressing their concern at the failure of some pension providers to honour guarantees and at the potential for insolvencies. The conduct of business division passed the letter to the prudential division, who decided to meet the Consumers' Association.

The prudential division told GAD that they had discussed the issue of Equitable's apparent low gross reserve and had decided to take a "low profile" approach to obtaining clarification of the basis for Equitable's reserving for GAR options. It had therefore been agreed that they would ask GAD to obtain this from Equitable, presenting it simply as a normal request for clarification of actuarial assumptions. They asked GAD for sight of a copy of their draft letter to Equitable.

27/05/99

GAD accordingly asked Equitable to explain how in their reserving calculation they had arrived at the proportion of policyholders taking benefits in GAR form, and how the reinsurance offset had been calculated. Referring to the solvency projections that Equitable had submitted on 04/05/99, they said that they were surprised at the low level of reserves required at the end of 1999 relative to the projected cashflow, and they asked for confirmation that no further material change had been assumed in valuation bases. They also asked for a projection of Equitable's position at the end of 1999 on the basis of a further scenario where gilt yields stayed at around 5%, while equity values fell by 10% over the year.

28/05/99

The conduct of business division contacted the prudential division about the concerns that the Consumers' Association had raised over insurance companies refusing to honour guarantees, and that companies might be concealing information from policyholders. The conduct of business division's view was that the first point was a matter for the prudential division, while the second was for them and would probably be addressed in the course of their routine supervision visits.

01/06/99

FSA's prudential division told the conduct of business division that they understood the Consumers' Association's main concern to be that policyholders were not being told when their policies matured that those policies contained GAR options, and they might therefore end up buying a lower value market annuity.

02/06/99

After further discussion of the issues raised by the Consumers' Association, the conduct of business division said that the position was unclear; there were issues about whether policies had been sold before or after the Financial Services Act 1986 came into effect; whether advice had been provided at the time of sale and by whom (a representative of the insurer or an independent adviser); and where a company's responsibilities lay. They had sought legal advice on the matter and were awaiting a reply.

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c02/06/99

An undated file note, apparently prepared by FSA's prudential division as briefing for a meeting with the Consumers' Association that had been arranged for 14/06/99, said that any reduction in terminal bonus was acceptable only to the extent that it was consistent with policyholders' reasonable expectations and that the acceptability of cutting the terminal bonus would depend on what policyholders had been told when they had taken out the contract and subsequently. The courts would clarify some issues, and FSA were awaiting their judgment before considering particular cases. However, in general, FSA saw GAR options as an additional benefit for which some charge could reasonably be made if costs were incurred in providing benefits. Most insurers based payouts for with-profits policies on asset shares, where the benefits equalled the premiums paid (less expenses) plus a proportionate share of the investment return achieved; reducing terminal bonus selectively to policyholders exercising a GAR option was consistent with that approach. The conduct of business division monitoring teams were looking at documentation issued to policyholders. A number of companies had taken steps to control their liabilities, through reinsurance or other hedging techniques. Companies had to reach a commercial judgment as to whether it was worth paying for protection of liabilities that might increase, decrease, or disappear altogether.

02/06/99

The conduct of business division noted that they regarded GAR options as broadly a prudential issue to be dealt with by the prudential division; the conduct of business division would await the outcome of the court case and the PIA Ombudsman's view on existing complaints.

c02/06/99

The then Economic Secretary queried why the reserving standards applied in the Treasury's regulatory returns (as set out in the relevant regulations) should be "almost always more onerous than those in general accounting standards".

04/06/99

FSA's prudential division provided GAD with a copy of their proposed advice to the then Economic Secretary on GAR option reserving. In draft paragraphs for the Economic Secretary, the prudential division said that companies had to take into account all reasonably foreseeable circumstances [prudential division emphasis] in setting their statutory reserves. Companies were not required to assume the absolute 'worst case' scenario but had to reserve to take account of potential adverse economic circumstances. They had to err on the side of underestimating the value of future income and overestimating liabilities. The determination of how conservative assumptions should be was derived from past experience and embodied in guidance to appointed actuaries.

On or about this date, GAD told the prudential division, in a note commenting on the issues raised by the then Economic Secretary, that insurance legislation required insurers to reserve for "all guaranteed benefits" on the basis of "prudent" assumptions; it also specifically provided that insurers must reserve for any additional costs of policy options. Equitable had set up a gross additional provision of £1.6bn at the end of 1998 for GAR liabilities. This was the provision for the additional liabilities they would face in applying the annuity rates guaranteed to policyholders to the cash benefits arising under the GAR pension contracts. The guaranteed cash benefits under these contracts were currently some £4.5bn, the total combined provision of £6.1bn was, in fact, close to the "fair share" of the accumulated fund that related to the GAR contracts. The cost of the GAR options and hence the reserving requirement had become significant due to recent falls in long term interest rates. Where Equitable had guaranteed rates in the region of £110 per annum per £1000 cash available, the best current market rate for an equivalent annuity was now only of the order of £80 per annum per £1000 of cash pension fund. GAD added that the reserving standards applied in regulatory returns were almost invariably more onerous than general accounting standards. In their statutory accounts Equitable were effectively assuming that equity prices would continue to rise so that the resulting capital gains produced surpluses of sufficient size by the time the GAR contracts matured to enable Equitable to discharge their liabilities to policyholders. While this might be acceptable in [statutory] company accounts, it would not be considered prudent in the regulatory accounts as it made no allowance for the risk that equity prices might fall and the assumed surpluses not arise. GAD said that their guidance on reserving standards had been widely endorsed within the actuarial profession and that a significant number of actuaries considered that a stronger reserving basis should have been required.

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09/06/99

GAD commented on an unattributed, undated paper (which FSA say was prepared by the prudential division and circulated on 08/06/99) setting out various possible outcomes of the court case; their comments were copied to the legal division. The prudential division's paper identified four possible scenarios and set out the implications, as the prudential division saw them, for both FSA and Equitable in each case. The four scenarios were that (i) Equitable won; (ii) Equitable won in part (namely that it was then acceptable to reduce the terminal bonus, but had not been so in the past); (iii) Equitable won (in total or in part) on contractual grounds, but FSA would have to take a view on the outcome's acceptability from the perspective of policyholders' reasonable expectations; and (iv) Equitable lost (meaning that reducing the terminal bonus where a GAR option was exercised was unacceptable). Under the third scenario the prudential division noted that they would expect to conclude that Equitable's practice was then acceptable, but it was more doubtful that it had been so in the past, when, they said, bonus notices had been of dubious clarity. They added that they needed to try to define some more detailed criteria for determining when a terminal bonus reduction was, and was not, consistent with policyholders' reasonable expectations. GAD, in comments on the prudential division's paper, pointed out that, unless Equitable's practices were given full clearance by the courts, modification or replacement of the reassurance arrangement was essential. The prudential division's paper said that under the fourth scenario Equitable would need to look at reducing substantially the terminal bonus payable to all policyholders (or those with a GAR option irrespective of whether it was exercised?) and the prudential division would need to assess the consistency of Equitable's actions with policyholders' reasonable expectations. The reinsurance cover could be invalidated and leave Equitable only just able to cover the required minimum margin of solvency. FSA would need to determine Equitable's regulatory solvency and might need to consider closing the company to new business or suspending their authorisation if their liabilities to policyholders or policyholders' reasonable expectations might not be met. There could be an increase in the lapse rate of policies, a need for a change in Equitable's investment policy, compensation for the GAR holders whose policies had already matured and the effect that all of those things might have on Equitable's financial position. If the impact led to a take-over bid the prudential division continued, FSA would have no authority to protect Equitable from it; policyholders' interests should be protected but the industry would lose a well respected company. There could be a fall in the level of new business. FSA would need to address concerns that policyholders were losing out and the prudential division saw potential for allegations that FSA should have prevented Equitable from writing new business earlier.

The prudential division provided the Treasury with comments on a draft reply to Equitable's letter of 30/04/99 to the then Economic Secretary.

11/06/99

By FSA's account, their prudential division contacted Equitable by telephone on this date and requested copies of relevant material in relation to the Court case.

14/06/99

The then Economic Secretary replied to Equitable's letter of 30/04/99 explaining the purpose of the requirements of the regulatory returns. She said it would not be appropriate for her to comment on, or intervene in, a particular case where there was dialogue between a company and the regulator. She said that companies had to take account of all reasonably foreseeable circumstances [her emphasis] in setting their statutory reserves. If the guaranteed benefits under the annuity option were higher than those available in cash form, then it must be prudent to reserve for the higher value benefit.

FSA's prudential and conduct of business divisions, with GAD, met the Consumers' Association. A note of the meeting, prepared by the prudential division, said that there appeared to be much more common ground between FSA and the Consumers' Association than FSA had expected. FSA had been able to alleviate the Association's concerns that insurers were not honouring their guarantees and the Association had acknowledged the difficulty of being fair to all policyholders in meeting the costs of GAR options and the appropriateness of the costs being met from the with-profits fund.

The prudential division told their legal division and GAD that they had asked Equitable for the court papers, which Equitable had agreed, subject to legal advice, to provide. The court hearing was due to start on 05/07/99 and had been scheduled to last for two or three days. Equitable had said that there was a possibility of significant delay before the judgment was published.

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15/06/99

FSA's legal division told the conduct of business division (who copied the advice to the prudential division on or around 14/07/99) that advice about GAR options given to, or withheld from, policyholders by companies after 29/04/88 - when the Financial Services Act came into effect - would be subject to the conduct of business rules, even if the policy had been sold before that date. Failure by a company to tell policyholders on maturity about their rights to GARs would undoubtedly breach PIA principles.

FSA's prudential division agreed to meet PIA Ombudsman staff on 23/06/99 to discuss complaints which the PIA Ombudsman had received about the cutting of terminal bonuses on policies with guaranteed annuities. They said that they would like also to discuss a number of other issues, including the PIA Ombudsman's jurisdiction on complaints concerning pre and post 1988 policies; the factors taken into account in an adjudication; how the PIA Ombudsman would reach a view on policyholders' reasonable expectations and the scope for them and the prudential division reaching a common view on that; and their handling of complaints. They said that they considered it important to understand the PIA Ombudsman's thinking in that area, as they would need to take a more general line on policyholders' reasonable expectations after the court judgment. They also wanted to understand the potential financial implications for insurers of the PIA Ombudsman's rulings.

16/06/99

The prudential division received a pack of materials relating to the court case from Equitable's then solicitors (as requested 11/06/99).

17/06/99

FSA's prudential and conduct of business divisions held a general bilateral meeting. They noted that the court case, and its implications for policyholders' reasonable expectations, would be a key milestone for guaranteed annuities. The prudential division said that they were waiting for the end of June regulatory returns from companies to review the basis of reserving for GARs.

In an internal e-mail the conduct of business division said that they had agreed with the prudential division at that day's bilateral meeting that FSA would pilot lead supervision (paragraph 36) with 11 firms, including Equitable. The e-mail was addressed to two of the conduct of business division's staff who would be directly involved in the pilot, and said that the scheme would involve meetings with their counterparts from the prudential division to discuss, among other matters, supervisory plans. The results of the pilot would be reported in October 1999. The e-mail asked that the recipients tell their prudential division counterparts of any visits planned for the following quarter to any of the firms concerned.

18/06/99

Equitable's solicitors sent FSA's prudential division a copy of the subordinated loan capital agreement and asked them to confirm that the Treasury would not require any alteration to the section 68 order consenting to the modifications made to the loan agreement dated 04/08/97. [See entry for 30/03/99.]

21/06/99

Equitable wrote to FSA's prudential division saying that their lawyers had advised them not to prepare a fully documented contingency plan on the grounds that it might be unhelpful were it to become discoverable in some future legal action. Equitable said they had, however, given considerable thought to the ramifications of the various possible outcomes of the case and had identified six possible scenarios. The scenarios were described in an attached note as: (i) complete success [for Equitable]; (ii) success but with some adverse comment; (iii) directors had discretion [to determine different levels of bonus to policyholders choosing the guaranteed annuity rate], but had incorrectly executed it on technical grounds; (iv) directors had discretion, but had not given sufficient weight to, or considered, policyholders' reasonable expectations; (v) Equitable's approach was invalid and final bonus rates on cash and annuity benefits had to be equal but the Board still had discretion to set rates at a level they deemed appropriate; (vi) Equitable's approach was invalid and that final bonus rates on cash and annuity benefits had to be equal, but due to policyholders' reasonable expectations had to be set at the cash levels. Equitable set out briefly the implications as they saw them for each of the scenarios identified. For scenario (vi) these were that an appeal was certain but the judgment would stand until the appeal was heard. A Special Board meeting would be held by Equitable to consider cutting the ongoing growth rates on policies with GARs. Any Board resolution would be backdated. Both retirements and surrenders were likely to be large; past retirements would almost certainly require further payment. They said that they were discussing with the reinsurer possible amendments to the reinsurance treaty to cope with the fifth and sixth scenarios and had been in discussion with other reinsurers regarding other types of arrangement. Their lawyers, however, considered all but the first and second scenarios to be highly unlikely.

c22/06/99

The prudential division prepared a paper following their review of Equitable's court documents. They said that Equitable's arguments revolved around their 'asset share' approach, and made no mention of policyholders' reasonable expectations. Equitable had indicated that, even were they to lose the case, they would look to spread the cost of GAR options across those policyholders holding such an option, irrespective of whether or not they exercised it

[i.e. ring-fencing]. Mr Hyman had been selected as he was the only complainant to the PIA Ombudsman whose policy had matured. Although the PIA Ombudsman had relinquished his jurisdiction on a number of complaints to the court, it was not clear whether he was still free to come to a different view on the basis of factors beyond the scope of the court, such as policyholders' reasonable expectations.

22/06/99

GAD briefed FSA's prudential division on the papers relating to Equitable's court case. They said that the papers appeared to demonstrate that Equitable had been cognisant of the GAR issue in 1993 and had taken action at the earliest moment that it had become relevant. There was an argument before the court that the Board's discretion to decide bonus levels could not be unfettered and absolute and must take into account other principles, particularly policyholders' reasonable expectations. It was also being argued that documents that Equitable had provided to policyholders had implied that bonuses would not be reduced where an annuity was taken at the guaranteed rate. GAD said that it was unlikely that the court would be able to ignore any consideration of policyholders' reasonable expectations; while the court could in theory decide that that was a matter for FSA, that seemed unlikely.

FSA's enforcement team began to investigate direct sales of pension fund withdrawals by Equitable who dominated this market.

At the FSA's Chairman's Committee, the director acknowledged that the relationship between the prudential division and the area of authorisations, enforcement and consumer relations could be further improved.

23/06/99

FSA's prudential division, accompanied by GAD, met the PIA Ombudsman. A note of the meeting said that Equitable had accepted the PIA Ombudsman's pre-1988 Act jurisdiction. The differential terminal bonus practice was at the core of policyholders' complaints and was an Equitable Board policy. Matters concerning Board policy and whether directors could act in a particular way were outside the PIA Ombudsman's remit. The PIA Ombudsman would look at policyholders' reasonable expectations only in terms of misrepresentation. If there were an appeal in the court case, the PIA Ombudsman would not communicate further with policyholders until after that had been decided.

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24/06/99

The prudential division asked the conduct of business division if they had reached a view as to whether information provided to holders of policies taken out before 1988 fell within their jurisdiction. They also asked whether the conduct of business division had any jurisdiction in relation to bonus notices issued to policyholders, and whether they could require Equitable to change those notices. The prudential division said that they had been unhappy for some time with the format of Equitable's bonus notices, as the way the terminal bonus was indicated was potentially misleading, and it was arguable that the format of the notice would encourage policyholders to believe that their guarantees would apply to the full fund, including the terminal bonus. The conduct of business division told the prudential division that they had concluded that they should look at the current bonus notice.

According to the Baird report, around this time the prudential division sent copies of Equitable's bonus notices for 1996 and 1997 to the conduct of business division for their views. They said that they would obtain copies of Equitable's 1998 notice the following week, commenting that the 1998 notice was expected to be more clearly drafted. [They did not send them Counsel's opinion advising Equitable to change the format of their bonus notices from 1998 onwards.]

GAD told the prudential and legal divisions that one of the more awkward scenarios that FSA should consider at that stage would be if the court found for Equitable in terms of contract law, but referred the issue of policyholders' reasonable expectations to FSA. Should that happen, FSA could apply a similar test to that used by the courts in judicial review, namely simply look at whether Equitable had acted in bad faith or had overlooked some salient fact. That would avoid the need to interfere in what might otherwise be seen as a commercial decision, which properly fell to the directors of the company. GAD said that in their view Equitable's asset share approach to distributing benefits was tenable, and that any question as to whether a policyholder had been misled at the point of sale would be for the PIA Ombudsman. As to Equitable's illustrations and bonus notices, if FSA were to regard those as giving rise to an expectation of how the GAR would be applied, then a similar question would need to be asked concerning the level of bonus indicated. A manuscript addition on the final point by a prudential division officer said "Yes but an indication (false) has been given". GAD offered three options:

  
1. The final bonus [at the level illustrated] could be regarded as binding in all circumstances; they doubted that a reasonable policyholder could interpret the illustrations as providing an absolute guarantee in all circumstances, and said that such an interpretation would have severe consequences for the whole industry, with many companies being unable to meet the resulting increase in liabilities.
  
2. The [illustrated level of] final bonus could be regarded as variable, but only in line with underlying investment conditions (which they said was more plausible). If it were held that that level of bonus was the expectation of holders of policies containing GARs, in the current investment conditions the result for Equitable could amount to an increased cost of £2bn. They would lose their reinsurance cover but would just remain technically solvent and would have to recoup the £2bn from other [non-GAR] policyholders, which could be commercially damaging and could impact on those policyholders' expectations. Their position as a mutual would become almost untenable, and they could be expected to argue that FSA had signed their death warrant.
  
3. The bonus could be regarded as variable, subject only to smoothing over a reasonable period of time. Equitable would remain solvent but would be weakened both commercially and financially.

GAD said that, overall, they would be inclined not to intervene in such circumstances, but that FSA might see some attractions in option (c).

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25/06/99

The prudential division prepared a paper on action FSA might need to take if the court did not give a substantive view on policyholders' reasonable expectations. They said that the legal division had advised that the test to be applied was whether it was reasonable to consider Equitable's approach consistent with policyholders' reasonable expectations, rather than whether they were adopting the best possible approach in that context. They did not consider it practical to reach a view on policyholders' reasonable expectations ahead of the court judgment, though they would undertake more work on that issue so as to be able to reach a view soon after judgment was given. They should flag up to Equitable at a forthcoming meeting that policyholders' reasonable expectations remained a live issue, lest Equitable were to infer from their silence that they were content. They said that the format of Equitable's bonus notices, which appeared liable to lead policyholders to unrealistically high expectations of their payout, were currently the main factor in support of the argument that Equitable's approach was not consistent with policyholders' reasonable expectations. They had raised this with the conduct of business division, and asked if PIA had the power to require changes to be made to the bonus notices. The prudential division had themselves previously raised that matter with Equitable (before the GAR issue arose) but had not made any progress in obtaining changes.

Equitable replied to GAD's letter of 27/05/99. They explained why they considered it appropriate to assume a lower level of take-up of GAR options than required under the guidance. They said that the reinsurance offset had been calculated on the assumption that any guaranteed benefits taken in GAR form above 25% would be covered by the reinsurer and paid back from future surpluses. With regard to questions that had been asked about their regulatory solvency projections, they said that the required level of reserves appeared low in proportion to their projected cashflow, because the latter item included both linked and non-linked business, whereas the item relating to reserves related only to non-linked business. They confirmed that there had been no material change in the valuation bases. The further scenario that GAD had asked them to apply to their projections would result in a ratio of available assets to minimum margin, at the end of 1999, of 1.4:1, assuming a declared bonus at ½% below that for 1998.

28/06/99

GAD responded to the prudential division's note of 25/06/99, saying that they felt that PIA and/or the Ombudsman might have a greater role to play if there was any suggestion of mis-selling by the salesforce. They also copied to them Equitable's letter of 25/06/99.

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29/06/99

Equitable met FSA's prudential division and GAD. A note of the meeting prepared by the prudential division recorded that Equitable had said that their lawyers considered it very likely that they would win the legal action, though perhaps with some adverse comment (the first and second of the outcomes considered in their letter of 21/06/99); they saw the final outcome listed, whereby final bonus rates had to be equalised for both cash and annuities at the cash level, as "inconceivable", as they did not believe that a judge could totally discount the scope of directors to exercise discretion over bonus levels. Equitable had not implemented any of the mechanisms for strengthening their position that had been discussed in the Board paper copied to the prudential division on 20/04/99. Equitable said that none of the first four outcomes listed in their letter would require a change to their bonus practice, and so invalidate the reinsurance. They believed that it would be possible to extend the scope of the treaty, should they lose the case. GAD pointed out that any extension to the scope of the treaty could have implications for Equitable's future profit implicit items. The prudential division pointed out that even were Equitable to win, that would not be the end of the matter as far as the regulator was concerned, because they would still need to consider whether Equitable's bonus policy was consistent with policyholders' reasonable expectations. They added that they had some concerns about the information contained in the bonus notices, but had not yet reached a view on that.

Equitable said they had adopted a new bonus payment approach which had been recommended by their legal advisers. They now paid an additional cash sum to policyholders who did not exercise a GAR option [as opposed to a reduction in the bonus payment to those who did]. They agreed to provide the prudential division with copies of the relevant information provided to policyholders. Equitable said that they would continue to offer good value to policyholders by paying out as much as possible in bonuses and not building up any hidden estate. They said that a lack of estate was a useful deterrent against predators, though that was secondary to Equitable's main historical objective, which was to pay out fair shares. Equitable said that they had been approached by a number of suitors, but their reply had been that they were committed to mutuality.

30/06/99

Equitable sent FSA's prudential division an example of a bonus notice for 1998, which they passed on to the conduct of business division for their views on whether or not it was misleading. Equitable also sent a copy of a letter dated 29/06/99 to policyholders about the court case.

July - December 1999