Case No. C.1597/01
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Part II: C.1597/01
Chapters 1 - 41 | Introduction |
| Chapters 42 - 101 | Background to the complaint |
| Chapters 104 - 167 | Further evidence & developments |
| Chapters 168- 238 | Chronology & conclusion |
Introduction
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 new 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.
2. The investigation began in December 2001 after my predecessor had obtained the comments of the Permanent Secretary at the Treasury. On taking up Mr P's complaint for investigation, my predecessor decided to limit the period under investigation to that from 1 January 1999 to 8 December 2000, which is from the point at which FSA began to conduct the prudential regulation of life insurance under contract from the Treasury until the closure of Equitable to new business. (The period coincided with that examined by FSA's own internal inquiry, as explained in paragraph 40, which had identified possible shortcomings in the prudential regulator's performance). When I took up post in November 2002, the investigation was at an advanced stage. I carried out a careful review of the position and decided not to depart from my predecessor's decision on the period under investigation; to have done so would have meant virtually restarting the investigation, and delaying my report by many months. However, as the detailed chronology of events shows, we have in any event had to look back at some of the earlier events to gain a proper understanding of the background to the period under investigation. I have not put into this report every detail investigated by my staff, but I am satisfied that, on the basis of the evidence that we have seen, no matter of significance has been overlooked.
Jurisdiction
3. Section 5 of the Parliamentary Commissioner Act 1967 provides that I may investigate any action taken in the exercise of an administrative function by, or on behalf of, a government department or other public body listed in Schedule 2 to the Act as being within my jurisdiction. FSA are not so listed and so fall within my jurisdiction only in so far as they were acting on behalf of the Treasury as prudential regulator before 1 December 2001. The Personal Investment Authority (PIA), which until 1 December 2001 had ultimate responsibility for conduct of business regulation, the Government Actuary's Department (GAD), which provided professional actuarial advice to FSA, and Equitable themselves are not so listed and their actions are therefore not within my jurisdiction. Thus, in so far as a complaint might relate to the terms and conditions of Equitable's policies, or the nature or calculation (or actual amount) of annuities or dividends payable to policyholders, or the conduct of Equitable's business including their marketing, sales and advertising, whether of personal pension, additional voluntary contribution, or any other plans, or any regulatory issues arising from the conduct of their business, I have no power to investigate such matters.4. Reference is made throughout this report to Equitable, PIA, FSA lawyers, GAD, and to FSA staff seconded to the PIA when acting as conduct of business regulator. I also refer to other bodies, including the Faculty of Actuaries and Institute of Actuaries (which I jointly refer to as the Faculty and Institute of Actuaries), Equitable's auditors, companies bidding to buy Equitable and law firms. I do so solely to put in context the actions of the Treasury or FSA as prudential regulator and since these bodies are all outside my jurisdiction, make no findings relating to their actions.
5. My remit is solely to investigate the administrative actions of those bodies within my jurisdiction. Under section 12(3) of the 1967 Act I may not question the merits of a discretionary decision taken without maladministration by such bodies; accordingly, providing the process by which the decision was reached was appropriate and the judgment reached was within the bounds of reasonable discretion, I cannot conclude that that decision was maladministrative. Further, the content of legislation or the possible need for its amendment are properly matters for Parliament to consider. Similarly, questions and disputes about the interpretation of legislation are matters for the courts to determine.6. This means, therefore, that I cannot question the statutory regulatory framework (including the statutory content and requirements of financial accounts and regulatory returns), within which the FSA carried out their prudential regulatory functions, and which I set out in more detail below. The regulatory framework was, and remains, a matter for Parliament. I should also make clear that, as that framework has changed since December 2001, when the Financial Services and Markets Act 2000 was fully implemented, and the implementation of regulatory functions is no longer vested in a government department or any other body within my jurisdiction, I do not believe it would be appropriate for me to make recommendations regarding possible changes to practices and procedures by which those regulatory functions are exercised.
7. This report contains references to opinions and advice obtained by Equitable and provided to the Treasury (subsequently FSA) in the course of normal exchanges between a regulated body and their regulator and for the specific purpose of allowing the Treasury to fulfil their regulatory functions. I acknowledge that Equitable have waived privilege in this material only for that specific purpose, and that, by agreeing to the inclusion of the material in this report, which it was understood would be published, Equitable do not intend any wider or general waiver of privilege.
Back to topStatutory and administrative background
The regulatory framework
8. Until 1 December 2001, when the Financial Services and Markets Act 2000 came into force, life insurance companies such as Equitable were subject to two regulatory regimes: prudential regulation and conduct of business regulation. Prudential regulation is concerned essentially with the solvency of insurance companies (in prudential regulatory terms this means that the company is able to meet a number of regulatory requirements, principally the required minimum margin - see paragraph 22) and the soundness and prudence of their management; conduct of business regulation relates primarily to the marketing and sale of a company's products and the provision of related advice to current and potential investors.
9. The objective of prudential regulation is to guard against a number of possible dangers. These are, in essence:
- that the insurance company might have insufficient assets to meet their contractual liabilities (the basic benefits provided under the policies and the reversionary bonuses)
- that the insurance company might be unable to meet the reasonable expectations of policyholders and prospective policyholders (see paragraph 33).
10. The statutory framework which governed the regulation of Equitable before 1 December 2001 was, for prudential regulation, the Insurance Companies Act 1982 (the 1982 Act) and, for conduct of business regulation, the Financial Services Act 1986 (the 1986 Act). The detail of the regulatory regimes was set out in a number of applicable Statutory Instruments supplemented by other non-statutory material such as the Personal Investment Authority (PIA) Rules and the actuarial Guidance Notes (see paragraph 24). The 1982 Act vested in the Secretary of State for Trade and Industry certain authorisation and supervisory functions related to the solvency of life assurance companies.
11. In January 1998, as part of the preparations to establish a single financial services regulator operating on the basis of a single legislative framework (which eventually came fully into being on 1 December 2001), responsibility for prudential regulation passed from the Department of Trade and Industry (DTI) to the Treasury. On 1 January 1999 the Treasury contracted out their functions and powers in respect of prudential regulation (with some exceptions - see paragraph 25) to FSA. The transfer of functions was effected by means of the Contracting Out (Functions in Relation to Insurance) Order 1998 (SI 1998/2842), and a service level agreement dated 18 December 1998 (the agreement) between FSA and the Treasury. Under the terms of the agreement, FSA had to "use its best endeavours" to meet the relevant service standards, in Schedule 1 to the agreement, which detailed (amongst other things) a number of circumstances in which FSA were required to alert the Treasury to regulatory issues arising either in relation to the insurance industry or to an individual company. FSA were also required under the agreement to provide the Treasury with a quarterly written report on the exercise of the [contracted out] functions during each preceding period and such other reports as might from time to time be specified. During this period, while FSA were accountable to the Treasury for the effective exercise of the contracted-out functions, the Treasury remained responsible for the prudential regulation of insurance companies and Treasury Ministers remained answerable to Parliament for its proper operation; day to day supervision of the insurance companies was undertaken by FSA.
12. Responsibility for conduct of business regulation had, since 1994, rested with PIA, which was a self-regulatory organisation. From 1 June 1998 until 1 December 2001 PIA undertook that function through the PIA Board with staff seconded from the FSA. On 1 December 2001, with the full implementation of the Financial Services and Markets Act 2000, full responsibility for both prudential and conduct of business regulation passed to FSA as the new single regulator for the financial services industry.
13. On 1 January 1999, when the Treasury contracted out their prudential regulatory functions and powers to FSA, virtually all of the DTI staff who had been seconded to the Treasury to be responsible for regulation of insurance companies in Treasury's Insurance Directorate moved to FSA, where they joined with others to form FSA's prudential division. This meant that, while FSA became accountable to the Treasury for the effective exercise of the contracted out functions, the bulk of the staff carrying out the work continued in their same roles.
14. FSA's aim in respect of the powers and functions conferred on them was described in the standard service specification associated with the agreement as:
"effectively to regulate the insurance industry so that policyholders can have confidence in the ability of UK insurers to meet their liabilities and fulfil policyholders' reasonable expectations.".
Key supporting objectives were set out and included: ensuring that persons or companies who are not fit and proper or appropriately resourced or otherwise able to satisfy the authorisation criteria do not carry on business in the UK; to regulate companies efficiently and effectively; to meet the industry's reasonable requests for information and advice, keeping the cost and inconvenience of regulation for insurers as low as is commensurate with effective consumer protection; and co-operating with the Treasury in seeking to deliver efficient operation of the single market. Key areas of work to be resourced during 1999 were: conduct of ongoing regulatory and related work to specified standards; supporting development of more effective and efficient regulatory procedures; and preparing for the new regulatory regime.
15. FSA's general responsibilities in this respect, as set out in the agreement, included prudential supervision of around 350 non-life companies, 200 life companies and 40 composite insurance groups, in addition to the supervision of Lloyds and some 80 companies in the London market. The agreement defined their key role as:
"Protecting policyholders against the risk of company failure and, more specifically, to protect them against the risk that UK authorised insurers might be unable to pay valid claims. In the case of life insurance companies this includes the risk that they will be unable to meet policyholders' reasonable expectations. The Treasury and FSA agree that it is neither realistic nor necessarily desirable in a climate which seeks to encourage competition, innovation and consumer choice, to seek to achieve 100% success in avoiding company failure. FSA will therefore pursue its supervisory objectives by aiming to minimise, but not eliminate, the risk of company failure by identifying early signs of trouble, and taking preventative action."
16. The service standard specification said that: 'The supervisory process is in an ongoing state of development ... the performance measures ... will be kept under review and amended from time to time as agreed between the Treasury and the FSA.'
17. The agreement also set out FSA's key tasks, which included: '"onitoring the financial soundness of insurers to see that they are run in a sound and prudent manner by fit and proper people, based mainly on the scrutiny of financial returns and other information (with the assistance of GAD, particularly in the case of life insurance companies), and site visits'"
18. The exercise of the powers or discretion conferred upon FSA by the agreement was in turn delegated to FSA's Insurance Supervisory Committee (the Committee), which comprised the director of the prudential division, the heads of department of the life, non-life, and London market sectors, and each of their respective managers. The head of the policy co-ordination unit, the insurance advisers, and representatives of GAD and FSA's General Counsel's Division (to which I refer as FSA's legal division) also had a standing invitation to attend.
19. GAD provided technical support to FSA under the terms of a separate service level agreement (as they had previously done for both the Treasury and, before them, DTI). That agreement set out in detail the services GAD would provide. In particular, they would scrutinise the regulatory returns of insurance companies (see paragraph 26) and advise FSA's prudential division as to what action should be taken following that scrutiny. To ensure appropriate prioritising of their workload GAD would carry out a brief initial scrutiny of the annual regulatory returns and assign priority rankings from one (high - a company at serious risk of collapse) to five (low). They then used this to assess whether a detailed scrutiny was required, subject to any views of FSA, scrutinised the returns in priority order and reported the results to the prudential regulator in the form of a 'scrutiny report', which formed a key element of the prudential regulatory process. (In Equitable's case, GAD were required to complete an initial scrutiny report by the end of the August each year following submission of the annual returns, and a detailed scrutiny by the end of the following February.)
20. GAD, both on their own initiative and on request from the prudential regulator, provided advice on areas that would impact on a company's regulatory solvency (see paragraph 22) or on the reasonable expectations of its policyholders. To ensure that GAD were fully informed, FSA's prudential division were required to copy to them all relevant correspondence received from insurance companies. In addition, GAD provided guidelines to companies on good practice in relation to particular actuarial issues. Their staff worked closely in support of FSA's prudential division, accompanying them on visits to insurance companies and advising them on a range of policy and technical issues.
21. Statutory restrictions (Schedule 2B to the 1982 Act inserted in 1994) meant that the prudential regulator could disclose restricted information (as defined) to the conduct of business regulator only where it was considered that the disclosure would enable or assist PIA in discharging their functions in their capacity as a recognised self-regulating organisation. I understand that there had been no formal regular contacts between the prudential and conduct of business regulators prior to both functions being carried out by FSA staff.
Principal regulatory actuarial and accounting provisions
22. Section 32 of the 1982 Act required insurance companies to hold assets which exceeded their liabilities by at least the margin prescribed by regulations. That was known as the required minimum margin and had to be maintained throughout the year, and not just at the year-end. Within the life insurance industry and frequently within this report, the term 'insolvency' or 'regulatory insolvency' is commonly used to mean the inability of a company to meet certain regulatory requirements, including principally the required minimum margin. In this context, the term does not imply inability to meet liabilities as in the more widely understood Companies/ Insolvency Acts meaning of the term, i.e. it is best understood as a regulatory trigger point or early warning mechanism. Section 32 makes it clear that breach of the required minimum margin might result in the prudential regulator requesting that a company provide it with a plan for the restoration of a sound financial position. The valuation of assets for the purpose of calculating the required minimum margin had to be in accordance with the Insurance Companies Regulations 1994 SI 1994/1516 (the 1994 Regulations). It was a further requirement that a specified proportion of the margin had to be covered by explicit available assets; in Equitable's case, as for most life companies, that proportion was one sixth. The remaining part could be covered by implicit items (assets which are intangible and relate, for example, to future profits from existing life business or hidden reserves resulting from the underestimation of assets or the overestimation of liabilities), although a section 68 order (see paragraph 25) in respect of those items had first to be obtained. A breach of Section 32 was one of a number of legal stages in an insurer's failure (these are listed in Appendix A).
23. Regulation 64 of the 1994 Regulations provided that the determination of long-term liabilities should be made on prudent actuarial principles, having due regard to the reasonable expectations of policyholders, and should include appropriate margins for adverse deviation of the relevant factors. It required that account should be taken of all prospective liabilities, including all guaranteed benefits and all options available to the policyholder under the terms of the contract.
24. This statutory requirement to include appropriate margins for adverse deviation of the relevant factors was understood by both regulators and actuaries as requiring not only the provision of such margins in each valuation factor but also that the valuation should be resilient to changes in circumstances, with special reference to more extreme changes to which a company might be vulnerable. The changes to be tested referred primarily to changes in investment conditions and the process of testing that a company was able to meet its regulatory solvency requirements in the event of significant hypothetical change in investment conditions was known as resilience testing. Monies set aside to ensure the company could cope with the adverse investment scenarios were known as resilience reserves, albeit part of the margins to meet resilience tests were often met by crediting 'excess' margins held elsewhere within the overall valuation basis. The 1994 Regulations did not indicate the range of eventualities that was to be allowed for in resilience testing; that was left to the professional judgment of the appointed actuary (see paragraph 27) and was the subject of one of a series of guidance notes (Guidance Note 8) issued to actuaries by the Faculty and Institute of Actuaries. GAD developed and kept under review guidelines as to the changes in market yields and equity prices that it might be prudent to take into account. They published the guidelines as letters (known as "Dear Appointed Actuary" (DAA) letters), sent to all appointed actuaries. While not mandatory, that guidance provided the de facto standard for prudent resilience testing. Advisory letter DAA10 from the Government Actuary, issued on 24 November 1998, amended the benchmark scenarios for resilience test 2. It said that, while the revised test was necessarily more complex, it was intended to avoid the unreasonable stringency which might apply if equity markets fell below their current levels. However, if applied to other types of business, it was not appropriate to include in the test any element which, taken overall, served to reduce the prudential effect of the test. FSA told my staff that an appointed actuary would be expected to use the most onerous of the tests; but it was open to the actuary to use an alternative basis for resilience testing, provided that the actuary could demonstrate to the satisfaction of GAD that the alternative was prudent and gave proper and meaningful implementation to the regulations.
25. Section 68 of the 1982 Act allowed for an order (a section 68 order) to be made which waived, or modified the application of, certain regulatory provisions of that Act. For legal reasons (namely the provisions of the Deregulation and Contracting-Out Act 1994, whereby departments could not contract out powers to make or amend legislation), the power to make such orders could not be contracted out to FSA in January 1999 and so remained with the Treasury until 30 November 2001 (after which date FSA took on full regulatory powers - see paragraph 12). Under the agreement between FSA and the Treasury (see paragraph 11), however, it was for FSA first to consider an application for such an order. If they decided that the application met the relevant guidelines, they were to provide the Treasury with advice setting out the background to the application, a recommendation and a draft order in the form of a draft letter. It was then for the Treasury to consider the Order and (as specified under the terms of the agreement - see paragraph 11) "clarify any points as necessary with FSA and/or Treasury solicitors and if satisfied, make the Order". Guidance issued by DTI to the industry during their time as prudential regulator, i.e. before 1998, said: "Orders in respect of future profits [see paragraph 28] and Zillmerising [see paragraph 30] will be readily available provided that the relevant requirements set out in this Guidance Note have been satisfied." Some 116 section 68 orders were given in 1999 and 165 in 2000, of which about 10% related to future profits implicit items, the calculation of which was set out in the 1994 Regulations (see paragraph 22).
26. In addition to the annual report and accounts required under the Companies Act 1985 (the statutory returns), section 22 of the 1982 Act required a life insurance company to submit to the prudential regulator each year a series of reports known as the regulatory returns. The Insurance Companies (Accounts and Statements) Regulations 1996 (SI 1996/943) set out in detail the information required in those returns and the format in which it was to be presented. The regulatory returns were considerably longer and more detailed than the statutory returns (those for Equitable ran to some 400 pages for each of the relevant years). The returns were designed to show not only the company's current solvency position but also, by the application of the resilience tests, their sensitivity to possible future adverse changes in the markets. The regulatory returns were the main tool from which FSA's prudential division, acting on advice from GAD, formed a view as to a company's (then) present and future regulatory solvency. At the time of the events giving rise to Mr P's complaint, companies were required to submit their returns to FSA within six months of their financial year end (which in Equitable's case meant by 30 June).
27. The 1982 Act required every life company to nominate an actuary, known as an appointed actuary, whose designation had to be notified to the prudential regulator before it could become effective. Regulatory approval was not however required for the appointment, nor did the regulator have powers to seek an actuary's removal on "fit and proper" grounds (see paragraphs 14 and 17). The appointed actuary was required to hold a valid practising certificate from the Faculty and Institute of Actuaries; and it was usual for the appointee to be interviewed by the Government Actuary on first appointment. The appointed actuary's role was, in essence, to advise the company's Board on actuarial matters, including the financial well-being of the company and, in particular, to be satisfied as to the solvency of the company at all times and that the reasonable expectations of policyholders (see paragraph 33) could be met. The appointed actuary had to advise the Board of any points of potential concern that might arise, and how they might be addressed; s/he also had a duty to advise them as to the interpretation of policyholders' reasonable expectations in relation to the company's own policies. Legislation required that the appointed actuary had to make an annual investigation of the company's financial condition. The report, which would normally be presented to the Board, had also to be included in abstract in the company's regulatory returns. Failure by an appointed actuary to comply with the profession's practice standards (such as one set out in the Faculty and Institute of Actuaries' Guidance Notes) could lead to disciplinary action by the profession. In evidence to the Treasury Select Committee, the Faculty and Institute of Actuaries said that the appointed actuary system was regarded as providing a more effective degree of monitoring of a company's financial situation than could realistically be expected of the regulator.
28. Regulations 24, 64 and 65 of the 1994 Regulations (paragraph 22) permitted companies, for the purposes of meeting the regulatory solvency requirements, to anticipate the likelihood that profits on investments would arise in future and be available to meet future liabilities. This placed a value on their future profits, which was known as a future profits implicit item and could be regarded as an (intangible) asset. However, such items could only be included in the calculation of assets for the purpose of covering the required minimum margin, provided that a section 68 order was first obtained (see paragraph 25). A future profits implicit item could take account only of profits - which in this context meant investment return - expected to arise on business that was already in place, and the maximum value of such an item could not exceed one half of the expected full amount of those profits. The Regulations provided that the level of future profits should be determined by multiplying the estimated annual profit by the average number of years - to a maximum of ten - remaining to run on policies. For this purpose, the estimated annual profit was to be taken as the average annual profit achieved over the preceding five years (this is known as the retrospective calculation). The appointed actuary also had to certify that the amount applied for was less than the present value of the profits actually expected to arise in the future on the in-force business (the prospective calculation). The appointed actuary was not required to state the assumptions used in the prospective calculation, or to provide the results of the calculation, although guidance issued in 1984 by DTI - which was still current at the time of the events subject to this investigation - said that appointed actuaries should use "cautious assumptions . similar to those required for the minimum basis for calculating mathematical reserves". (Mathematical reserves are based on a mathematical calculation of the basic reserves required to meet all prospective liabilities, including additional measures of prudence which at a minimum satisfy those laid down in regulations.) The DTI guidance also said that any exceptional profits that might have accrued over the period in question had to be excluded from the calculation.
29. Reinsurance is a process by which a life insurance company can effectively transfer part of its risk under a contract to another company, thus enabling the first company to hedge large or unusual risks and reduce the effect of variations in claims from year to year. Under The Insurance Companies (Accounts and Statements) Regulations 1996 reinsurance can also sometimes be used to improve a company's disclosed statutory solvency position - this is often known as financial reinsurance. Under a financial reinsurance arrangement the reinsurer may be entitled to recover from any future surpluses any payment made under a financial reinsurance agreement, although that entitlement is subordinate to the contractually guaranteed rights of policyholders. Reinsurance recoveries, prudently valued, can be included as an asset in the annual returns but the obligation to repay the reinsurer does not need to be recognised as a liability in the returns as its payment is contingent on future surpluses emerging. The reinsurer takes the risk that surpluses do not emerge and hence claims do not get repaid. If a company obtains reinsurance from an overseas insurer not subject to UK regulatory requirements, a looser regime may apply to the sums reinsured; this is often referred to as 'regulatory arbitrage'.
30. Under Regulation 25 of the 1994 Regulations (paragraph 22) life insurance companies could reduce the calculated reserves for liabilities by an adjustment known as a Zillmer adjustment. That allows the initial expenses incurred by a company when writing new business to be spread over the lifetime of the policy in proportion to the premiums due. In this way the initial costs are offset against the future income arising from that policy. Zillmer adjustments are applied only to policies where regular premiums are payable.
31. The 1994 Regulations also provided that funds raised from the issue of loan capital did not count toward a company's assets for the purpose of calculating the required minimum margin, because the value of the money received would be offset by a corresponding liability to repay the loan together with interest. However, the Regulations did provide that such funds could be counted if the obligation to repay the loan was subordinated to the rights of policyholders and a section 68 order was obtained.
Prudential regulator's powers of intervention
32. The prudential regulator's primary objective is the protection of policyholders and potential policyholders and to that end they may use a range of powers of intervention. Under section 11 of the 1982 Act first DTI, from January 1998 the Treasury, and from January 1999 FSA, had the power, either at the request of the company or on any of the specific grounds listed, to issue a direction withdrawing the company's authorisation to conduct new business. One of the grounds so listed was that the criteria of sound and prudent management were not, or had not (or might not have) been fulfilled. Before giving a direction to the company under section 11, the prudential regulator had to serve on the company a written notice stating that they were considering giving a direction and the grounds on which they were considering it. The company could then, within one month of that notice being served, make written (or if the company so requested, oral) representations to the prudential regulator. The prudential regulator was then required to take those representations into account before giving a direction. The company could at any time seek judicial review of the prudential regulator's actions. That would not, however, in itself prevent the regulator from taking action, unless an order of prohibition were obtained within the Judicial Review proceedings; a company could also obtain a court injunction. Under section 12A of the 1982 Act, which was inserted in 1994, the regulator could withdraw immediately a company's authorisation to accept new business for a period of up to two months while they considered representations from that company. (This power was essentially an expedited procedure for withdrawing authorisation under section 11 and could therefore only be used if grounds under section 11 existed and the regulator considered that the authorisation needed to be withdrawn as a matter of urgency.)
33. Section 37 of the 1982 Act provided that the prudential regulator could intervene (through using a range of powers set out in sections 38 to 45 of the Act - see paragraph 34) to protect "policyholders or potential policyholders" against a risk that a company might be unable to meet its liabilities, or to fulfil the reasonable expectations of policyholders or potential policyholders (see paragraph 14). While there was no statutory definition of the concept of policyholders' reasonable expectations, it was generally accepted within the actuarial profession and the insurance industry as extending beyond the expectation simply that contractual liabilities or other legal rights would be met. Most with-profits policies contain some element of discretionary annual and terminal bonuses, and it was seen as reasonable that holders of such policies should expect companies to behave fairly and responsibly in exercising their discretion to distribute them. For with-profits business, policyholders were entitled to expect that benefits would reflect the asset share, which was the actuarially adjusted accumulated value of premiums paid, less deductions for expenses, tax and other charges, plus allocations of business profits or losses, accumulated at the rate of investment return achieved (effectively the proportion of a fund attributed to each investor). The focus in the case of such policies would be the total benefit payable at maturity. Traditionally asset share (subject to a smoothing process, that is averaging out the peaks and troughs of short-term stock market movements) had been regarded as providing the starting point for determining what that benefit should be. Guidance published by DTI in a Ministerial statement in February 1995, in the context of attributing surpluses in with-profits funds, said that policyholders' reasonable expectations would be influenced by a range of factors, notably: fair treatment of policyholders vis-à-vis shareholders; any statements of a company's bonus philosophy; a company's history and past practice; and general practice within the industry. According to a paper prepared for the FSA Board in January 1999, DTI had also received legal advice from Treasury Counsel, in respect of a scheme unrelated to these events which involved a policyholder vote, that the Secretary of State could not abdicate her responsibility for protecting the reasonable expectations of policyholders by simply leaving the issue for policyholders to decide. The regulators had to make their own decision as to whether proposed payments would meet the reasonable expectations of policyholders.
34. Section 43 of the 1982 Act enabled the prudential regulator to require a company to submit regulatory returns earlier than the date specified in the Act, at a date no earlier than three months before the end of the specified period. Section 45 of the 1982 Act enabled the prudential regulator to require a company to take such action as appeared appropriate "for the purpose of protecting policyholders or potential policyholders of the company against the risk that the company may be unable to meet its liabilities or, in the case of long term business, to fulfil the reasonable expectations of policyholders or potential policyholders". (This was effectively a reserve power to be exercised only where FSA considered that the above purpose could not be appropriately achieved by exercise of its more specific powers, as cited above, or by the exercise of those alone.) Because the exercise of intervention powers might bring about consequences which the regulator would otherwise want to avoid, including the possibility of adverse consequences for policyholders, regulatory judgment has to be exercised in deciding whether or not to intervene.
Regulatory approach
35. When FSA was established in 1998, nine regulatory regimes were brought together. The regimes for the prudential regulation of life insurance had not previously been as intrusive or as heavily resourced as some of the other regulatory regimes. The style adopted by the prudential regulators was variously described by them to my staff at interview as "passive", "light touch" and "like negative vetting", meaning that, while no regulatory intervention would be taken against a company unless a regulatory rule had been broken, informal pressure would be brought to bear. The philosophy of the regime, in contrast to those that had applied in some of the other financial sector regulatory regimes, such as banking, which concentrated on product and tariff control, was to allow consumers to benefit from competition between insurers through the downward pressure on prices and greater choice of products. The aim was to promote competition by combining maximum freedom for regulated companies within the rules, including the right to decide the nature of their policies and premium rates, coupled with full disclosure by them of relevant information. This approach was generally characterised as "freedom with disclosure".
36. In June 1999 FSA introduced lead supervision arrangements as a first step towards becoming a single integrated regulator. Lead supervision was intended to improve the effectiveness of FSA's supervision of groups or firms with more than one authorisation. The three key responsibilities of the lead supervisor were to prepare an overall assessment, to establish a co-ordinated supervisory programme, and to be the central point of contact. The lead supervisor's role was to understand and evaluate the group's business strategy, management capabilities and policies, systems and controls, resourcing and economic environment, and to prepare a risk-based plan of supervision over a specified period. The lead and other supervisors would normally agree the plan annually at a regulatory college meeting. The lead supervisor would ensure that information passed to him or her was disseminated properly and quickly within FSA.
37. Senior officials from the Treasury, FSA and the Bank of England meet monthly as the Standing Committee on Financial Stability, also known as the Tripartite Standing Committee. The Committee may also meet at other times when there is considered to be an urgent threat to the stability of the UK financial services industry.
Other enquiries into these matters
38. In December 2000 the Faculty and Institute of Actuaries announced that they were setting up an Independent Committee of Inquiry led by Mr Roger Corley to look into the events surrounding the closure of Equitable to new business and its implications for the profession in terms of the adequacy of professional guidance and the implications for the role of the actuary. The Corley report, which made a series of recommendations designed to improve and strengthen actuarial guidance, was published in September 2001.
39. Meanwhile, on 31 August 2001 the Government had announced that it would set up an independent inquiry, chaired by Lord Penrose (the Penrose Inquiry). The terms of reference of the Penrose Inquiry are:
"To enquire into the circumstances leading to the current situation of the Equitable Life Assurance Society, taking account of the relevant life market background; to identify any lessons to be learnt for the conduct, administration and regulation of life assurance business; and to give a report thereon to Treasury Ministers".
Lord Penrose has announced that he aims to report to Treasury Ministers by summer 2003.40. On 16 October 2001 FSA's report of the findings of their own internal review was published as a House of Commons paper (HC244). I shall refer to this as the Baird Report. The review was led by Mr R Baird, FSA's then Head of Internal Audit, and considered their regulation of Equitable from 1 January 1999 to 8 December 2000. The terms of reference of the review were set by FSA's Board and included: providing an independent account of events with professional support; FSA's discharge of functions contracted out by the Treasury; PIA's discharge of their functions; describing the background and events leading up to FSA assuming responsibility for prudential regulation of Equitable; describing the course of supervisory work from then until Equitable's closure to new business on 8 December 2000; and identifying any lessons to be learned. The Treasury submitted the Baird Report as evidence to the Penrose Inquiry. A summary of the report's recommendations and FSA's response to them is at Appendix B. As the Baird Report identified some apparent shortcomings on the part of the prudential regulators during that period, my predecessor decided to launch an investigation into the discharge by FSA (on behalf of the Treasury) of their prudential regulatory functions with respect to Equitable. I have regarded the complaint by Mr P, a long standing Equitable policyholder, who purchased an Equitable annuity in June 2000, as representing all the hundreds of others of investors who have complained to me about the prudential regulation of Equitable. The investigation has, however, been limited to the period covered by the Baird Report.
My investigation
41. After the investigation began in December 2001, my staff obtained papers from the Treasury almost immediately and - after some delay while consideration by all parties was given to certain legal issues raised by the third European Directive on life insurance - from FSA. The contents of the papers seen are summarised in the chronology of events at Appendix C to this report. My staff interviewed several past and present FSA staff members, a then member of GAD, and past and present members of Treasury staff (and a summary of that evidence is included in this report). I have also had the benefit of the advice of a specialist in actuarial matters, who was recommended to me by the Faculty and Institute of Actuaries.
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