Appendix C: Summary of events
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Summary of events: C1597/01
1957 -1998
1957
According to the Baird and Corley reports, Equitable's first life insurance contracts to include a Guaranteed Annuity Rate (GAR) were sold.Equitable began to include a GAR option based on a current interest rate of 4% for some pension policies allowing the policyholder on retirement to exchange some or all of the benefits the policy provided for an annuity at a rate guaranteed in the policy.
1971
The Finance Act made it possible for a policyholder to take part of the policy benefit in cash instead of in an annuity.1975
Equitable increased the interest rate on which the GAR was based from 4% to 7%, where it remained until 1988.
Equitable introduced terminal bonuses for with-profits business; some other companies had already done this.
1988
29/04/88
The Financial Services Act 1986 regulatory regime came into force.
30/06/88
Equitable ceased to offer GARs on new policies.
GAR policies were sold with increased flexibility following introduction of open market options in the legislation of the mid-1980s.
1989
20/03/89
A paper presented to the Faculty and Institute of Actuaries by Equitable's then appointed actuary said: "we do not believe in the concept of an estate in the sense of a body of assets passed from generation to generation and which belongs to no-one".
1993
10/93
For the first time Equitable's GARs briefly exceeded then current annuity rates and the guarantee became a valuable benefit to those policyholders whose policies were maturing.
22/12/93
Equitable approved their then appointed actuary's proposal to adopt a differential terminal bonus policy.
1994
01/01/94
Equitable adopted differential terminal bonuses to reduce the advantage GARs would otherwise have conferred on eligible policyholders.
The Personal Investment Authority (PIA) became responsible for conduct of business regulation of PIA member companies.
05/94
Current annuity rates once more exceeded Equitable's GARs (until May 1995).
07/94
Equitable joined PIA.
15/12/94
Equitable applied for the first of an annual series of section 68 orders (paragraph 25) permitting a proportion of future profits to be included as an implicit item in calculating the cover for their solvency margin; the application, which was granted, was for £500m.
1995
24/02/95
A Ministerial statement (made in the context of attributing surpluses accumulating in with-profits funds) set out the concept of policyholders' reasonable expectations and the then regulator's view of the factors which influenced these in respect of the attribution of surpluses in with-profits funds. [These are listed in paragraph 33 of the report.]
05/95
Equitable's GARs began consistently to exceed current annuity rates.
28/06/95
Equitable applied for (and were subsequently granted) a section 68 order in respect of 1995 for £500m.
1996
26/06/96
Equitable applied for (and were subsequently granted) a section 68 order in respect of 1996 for £600m.
11/96
The then prudential regulator (DTI) and GAD visited Equitable for a routine regulatory visit as part of a three yearly cycle of such visits.
1997
01/97
The Faculty and Institute of Actuaries set up a working party to review the GAR option issue and survey the reserving practices of life insurance companies.
20/05/97
The Government announced plans to reform the structure of financial services supervision. A key aim of the reform was to bring together the various regulatory bodies into a single organisation operating within a single, coherent legislative framework. This resulted in the creation of the Financial Services Authority (FSA). [The resulting legislation was the Financial Services and Markets Act 2000, which came fully into force on 01/12/01.]
c06/97
Current annuity rates began consistently to fall below GARs for companies generally.
30/06/97
Equitable applied for (and were subsequently granted) a section 68 order in respect of 1997 for £700m.
04/08/97
Equitable, through a subsidiary, created bonds to fund a £350m loan subordinated to the rights of policyholders.
19/08/97
DTI granted a further section 68 order which allowed Equitable to take credit for the subordinated loan in their regulatory returns.
26/11/97
DTI told the NHS that there were no points of contention between them as regulators and Equitable. There were no material factors that might influence a NHS decision to appoint Equitable to provide an additional voluntary contributions pension scheme for NHS staff.
30/11/97
The Annuity Guarantees working party of the Faculty and Institute of Actuaries (01/97) considered three possible approaches to reserving for GARs but found that the variation between products and between the approaches of different companies to managing the guarantees was so great that they felt unable to recommend a single approach. They said that not reserving for such guarantees on the grounds that terminal bonus adjustments would be used and were sufficient to cover guarantees in all circumstances [Equitable's then approach] could be viewed as "unsound" because no explicit provision was made for an explicit guarantee.
16/12/97
In their scrutiny report on Equitable's 1996 regulatory returns GAD noted that Equitable were highly regarded and the oldest mutual life assurance society in the world. They paid no commission to intermediaries, achieved outstanding business growth, and had a reputation for "astonishingly low expenses". About 65% of their liabilities related to with-profits business. Because guaranteed bonuses included credit for a measure of asset appreciation, future bonus declarations seemed vulnerable to any sustained stockmarket downturn. GAD also noted that Equitable had a modest free estate (funds held within an organisation that are not attributable to any particular member or group of members). They raised some questions about the strength of the reserves established, in particular the provisions made for resilience, capital gains tax and pensions mis-selling. GAD reported that the section 68 order for a future profits implicit item granted for 1996 was £600m, £313m of which had been used but was not needed to cover the required minimum margin (paragraph 22). They also noted the existence of the £350m subordinated loan and that Equitable made little use of reinsurance.
GAD gave Equitable a priority 3 rating (paragraph 19); cover for the required minimum margin was 2.53. They commented that they did not consider there were any actual potential solvency problems for Equitable, but it would be desirable for them to hold back more of their emerging surplus by declaring lower guaranteed bonuses. GAD also said that it might be desirable for Equitable to give greater prominence in their literature to their policy of penalising early surrenders in relation to guaranteed bonuses; and it would be desirable for policyholders to be given greater warning about the possible implications for future bonuses of a substantial market setback. (GAD did not question a Zillmer adjustment (paragraph 30) shown in these and subsequent returns until late 2000.) GAD wrote to Equitable about a number of the questions arising from their scrutiny report.
1998
05/01/98
The Treasury took over from DTI responsibility for prudential regulation. The then DTI staff were seconded to Treasury but remained in their previous location, becoming Treasury's insurance division.
13/01/98
Equitable responded to the questions raised in GAD's letter of 16/12/97. They confirmed that, at 31/12/96, the total face value of policies, including accrued final bonus, was in excess of the value of the assets attributable to with-profits business.
16/01/98
GAD told Equitable that the above confirmation did not necessarily cause them any concern. However, the lack of any unutilised free estate brought to prominence the importance of not building up policyholder expectations too far such that it might then be necessary to hold reserves for anticipated final bonus additions.
04/02/98
Equitable told GAD that their bonus statements emphasised that the final bonus element of the current policy value was not guaranteed; they were acutely aware of the need not to build up inappropriate expectations.
19/02/98
Equitable's appointed actuary told their Board that a life insurance company had a number of measures available to manage solvency. There was no need to take avoiding action at an early stage merely because a position of regulatory difficulty was seen as an outcome of a possible scenario (but one which might well not happen). Provided the regulatory solvency position was kept under regular review, as it was for Equitable, and the implications kept in mind, there was no need to allow regulatory considerations to influence behaviour until it was felt that an unsatisfactory outcome was reasonably likely without some change of direction.
27/02/98
GAD told Equitable they did not intend to imply that they were considering outlawing the type of bonus notice issued by Equitable, but it would be a concern if any holders of accumulating with-profit contracts were ever to feel they had been misled. Equitable's manner of operating meant there was not much of a cushion to protect policyholders from the natural effects of future falls in asset values. GAD were confident that Equitable were aware of that.
GAD told Treasury's insurance division that their scrutiny of Equitable's 1996 returns was complete. GAD were basically satisfied with the prudence of the reserving bases (mathematical and resilience) which Equitable were applying. However, the position was very tight because of the way Equitable operated and GAD were accordingly keen to ensure that they should not build up any false expectations for their policyholders, as it would be hard to establish reserves for any greater liabilities.
21/04/98
GAD asked to meet Equitable to discuss bonus methodology, policyholders' expectations and reserving.
29/04/98
Equitable told a policyholder that they held "the prestigious AA (Excellent)" rating for financial security from a named private sector rating agency.
28/05/98
Equitable visited GAD to discuss a range of issues, including reserving matters [see entry for 08/06/98].
01/06/98
FSA seconded staff, some of whom had previously been PIA employees transferred to FSA, to the PIA to perform conduct of business regulation.
08/06/98
GAD reported to the Treasury's insurance division the outcome of the discussions with Equitable on 28 May. They confirmed that scrutiny of Equitable's regulatory returns for 1996 was closed, and that no strengthening of reserves was needed in relation to accumulating with-profits business. However, they said, they remained concerned that not all policyholders in Equitable and other life companies appreciated what could happen to future bonus declarations if there was a sudden downturn in asset values. The whole industry were relying on a soft landing, so that reductions in future bonuses could be achieved gradually and without trauma.
GAD told Equitable, following the 28/05/98 meeting, that there was little more at that stage to be said or done in relation to reserving. GAD said that Equitable had agreed that great restraint should be exercised in setting guaranteed bonus levels at a time when a large part of investment returns was being derived from capital gains. GAD said that they remained concerned that policyholders might not understand if a time arose when total attaching bonuses (the overall level of bonus payable on a policy) were necessarily cut - although other companies would be likely to disappoint earlier than Equitable.
20/06/98
GAD initiated a survey of the approach of life companies to reserving for guaranteed annuities.
26/06/98
Equitable applied for a section 68 order in respect of 1998 for a future profits implicit item of £850m.
c30/06/98
Equitable submitted their 1997 regulatory returns, which included a future profits implicit item of £371m by the due date. [GAD were scheduled to undertake the initial scrutiny and report the results to the Treasury by the end of August - see 31/08/98.]
29/07/98
Responding to GAD's survey of 20/06/98, Equitable said they had made no explicit provision for GARs in setting resilience or mathematical reserves; their investment policy took no account of the guarantees. Equitable's approach had not been modified by the debate within the actuarial profession on annuity guarantees. The cost of annuity guarantees had been more than adequately covered by the terminal bonus cushion to date for all but a few policies. Policyholders could pay additional premiums to which the guaranteed annuity rate would apply. As the business to which the guaranteed annuities applied aged, the increasing terminal bonus cushion made it increasingly unlikely that guarantees would actually bite [that is, require additional resourcing]. Not all policyholders were advised at retirement that there was a GAR option available to them.
31/07/98
GAD concluded their survey, which suggested that eight companies should be called in for discussions about their practices. Equitable and one other company were notable exceptions to industry practice in not holding substantial reserves to cover GARs, and Equitable seemed to be particularly vulnerable because the relevant business was approaching 30% of their total. (A different eight companies said they used the same differential terminal bonus approach as Equitable.)
08/98
From early August the media began to comment about the costs of guaranteed annuities to insurance companies.
13/08/98
GAD provided the Treasury's insurance division with a paper discussing the increasing value of GAR options resulting from lower interest rates and lighter mortality (average life-span had increased, with the result that people drew their pensions for longer). They said that companies now faced a significant problem with regard to GAR options, the scale of which GAD were investigating. GAR options existed in large numbers and threatened solvency in many cases and the actual, if not necessarily reasonable, expectation of policyholders in even more cases. There was a risk of them becoming the regulators' problem. The paper asked if varying the terminal bonus according to the cost of the GAR options met policyholders' reasonable expectations. GAD told the Treasury that, in their view, the terminal bonus could be restricted to keep down the cost of a GAR option, depending on the wording of individual policies. This would not however justify a lower reserve as the terminal bonus itself was not reserved for. To the extent that the GAR option applied to the full sum, the full pain had to be borne.
23/08/98
A newspaper article noted that some insurers might not be able to identify which policies contained a guarantee and, as policyholders might not have been aware of their entitlement, some may have received lower pension incomes than their due.
28/08/98
FSA's conduct of business division sent their media relations division and the Treasury's insurance division a memo referring to press comment on difficulties relating to GARs and saying that the matter was outside PIA's scope as the sales had occurred before the Financial Services Act 1986 had come into force. However, as the GAR issue also raised the question of solvency, the Treasury's insurance division were also investigating.
31/08/98
GAD's initial scrutiny report on Equitable's 1997 regulatory returns was due to be sent to the Treasury. [According to FSA, when it was subsequently decided to ask Equitable to submit their 1998 annual regulatory return early - see entry for 07/01/99 - it was decided to hold over the detailed scrutiny of the 1997 annual regulatory return and complete the review of that annual return alongside the detailed scrutiny of the 1998 annual return. That detailed scrutiny was completed in May 1999.]
09/98
GARs in many Equitable policies were by now some 30% above current annuity rates.
FSA's conduct of business division began to receive complaints about Equitable's treatment of GAR options.01/09/98
GAD gave the Treasury's insurance division advice on company behaviour in relation to GAR options, including when a company should tell a policyholder if a GAR was valuable, which they said PIA should police. They said that the Treasury had a duty to ensure that policyholders' reasonable expectations were met along with other prudential matters. They suggested that the Treasury should circulate a note to all companies saying that avoiding GAR option obligations was unacceptable behaviour. All companies should be asked to report on the procedures in place to ensure that guarantees were included in quotations and the Treasury should use any complaints to trigger a visit to the company to review procedures. GAD concluded that a more proactive course, reviewing companies routinely, would be too resource intensive to be practical and would be open to criticism as a misuse of powers.
03/09/98
The Treasury's insurance division asked GAD for a meeting to discuss the issues raised.
The Treasury's insurance division sent a memorandum to FSA's relevant managing director whose remit included the regulation of insurance, and copied it to the conduct of business director. The Treasury noted recent media interest in GAR options and told the managing director about the GAD survey. They said that they would be considering the implications of the survey results for the fulfilment of policyholders' reasonable expectations. They said that the conduct of business division would have an interest in the extent to which companies were informing policyholders of the existence of GAR options when they came to make choices on retirement. This was an issue where both sets of regulators would need to work closely together to ensure a seamless regulatory approach.
08/09/98
Equitable received legal advice that their differential terminal bonus policy might be open to challenge. (This advice was not shared with the FSA.)
15/09/98
GAD told the Treasury's insurance division that it was reasonable to grant the section 68 order requested by Equitable on 26/06/98. They enclosed a copy of Equitable's reply to their survey dated 29/07/98 and commented that Equitable had a problem with GARs but saw no need to reserve for them as they reduced the terminal bonuses to balance out the additional costs. GAD recommended that the Treasury should explore the subject further by asking Equitable for relevant marketing literature in support of their approach in order to be satisfied that policyholders' reasonable expectations were being met.
17/09/98
Equitable reviewed with Counsel their GAR policy and options.
21/09/98
The Treasury's insurance division asked Equitable for relevant marketing literature or other evidence that their approach of reducing terminal bonuses met policyholders' reasonable expectations.
25/09/98
The Treasury granted Equitable's application (of 26/06/98) for a section 68 order for a future profits implicit item of up to £850m.
29/09/98
Equitable told the Treasury's insurance division that they adopted the unusual approach of guaranteeing full value benefits on retirement whenever it occurred. This was the fairer course for all. Equitable said that they recognised that guaranteed annuities could become valuable when interest rates were low. Their terminal bonus practice was intended to achieve equity between those taking benefits in cash or annuity form. The aim was to pass on 'smoothed earnings' achieved over the lifetime of the policy. (This was a way of ensuring that policyholders did not receive unduly high or low benefits as a result of fluctuations in equity values at the time the policy vested.) As terminal bonuses were allotted only at retirement they could vary and were not guaranteed. The presentation of results to clients concentrated on the vast majority who were interested in taking the cash option rather than an annuity. Equitable had first introduced the practice of paying a lower terminal bonus where a GAR option was exercised at the end of 1993; that practice had been disclosed in their returns to DTI each year since. All clients with policies containing GARs had had at least two annual statements describing Equitable's bonus philosophy.
01/10/98
Equitable sent the Treasury's insurance division a copy of a 1980s retirement annuity policy document containing GAR options and a copy of Article 65 from their Articles of Association, which gave directors discretion on awarding bonuses.
02/10/98
The Treasury's insurance division and GAD met Equitable to discuss Equitable's approach to deciding what benefits policyholders with GAR options received and the implications for solvency. The Treasury note of the meeting said that it had been agreed that Equitable would provide a revised assessment of the reserves required for GAR options. GAD and the Treasury would then consider the status of the future profits implicit items concession. Equitable said that their constitution gave them powers to vary terminal bonuses for different cohorts of policyholders. GAD, however, considered that the policy wording was open to interpretation. Equitable said Counsel had advised that they were acting fully within their rights. Equitable added that many of their policies to which GARs applied allowed payment of additional premiums, but that this was not a risk, owing to their treatment of asset shares; they accepted, however, that switches of policies into Equitable were a risk.
GAD said that guarantees should be reserved for whether or not they were biting [that is, where the guaranteed rate was higher than the current annuity rate]. In their view Equitable should look at all their guarantees and options and make appropriate reserves. Equitable objected, saying that that could have severe consequences for them. They were concerned that in the then current climate tougher regulatory controls could tip companies into insolvency. However, Equitable agreed to assess the need to provide reserves for GAR options and to reassess solvency. The Treasury agreed that, if approached, Equitable could say that they "had responded to the GAD survey ... and they have been in communication with the Treasury with respect to that survey".
07/10/98
An Equitable policyholder wrote to the PIA Ombudsman complaining that Equitable intended to reduce the bonus payable under his policy if he chose to take an annuity at the guaranteed rate. The letter was copied to the Treasury's insurance division.
09/10/98
GAD told the Treasury's insurance division that companies needed guidance on their joint interpretation of policyholders' reasonable expectations for GAR options. It was GAD's view that policyholders with GAR options could reasonably expect to pay some premium or charge towards the cost, resulting in some reduction of the final bonus that would otherwise be payable. GAD said that they expected to see the cost met first out of any estate held within the fund, then by adjusting the future bonus allocations in the context of policyholders' reasonable expectations, which would be influenced by their policy documents and any representations made by the company.
19/10/98
At the request of the then Economic Secretary, the Treasury's insurance division briefed her on Equitable and their exposure to GARs. The Treasury said that they intended to issue guidance to the industry on handling GAR options in the context of policyholders' reasonable expectations. They explained that meeting the cost of GARs was putting a significant strain on Equitable's finances. As a mutual, Equitable did not have the option of a capital injection from shareholders. It was feasible that they would have to consider some form of de-mutualisation through merger, depending on how serious the financial situation proved to be. They had asked Equitable for more up-to-date information and the Treasury would monitor that and take any action necessary to protect policyholders' interests. Their initial view, on the evidence they had seen, was that Equitable's approach was consistent with the terms of the contracts sold and Equitable were endeavouring to fulfil the reasonable expectations of all their policyholders. They concluded that it was reasonable for policyholders to pay a charge towards the cost of the GAR option, provided this was allowed for in the terms of the contract. They proposed, subject to the then Economic Secretary's approval, shortly to prepare guidance on those lines for the industry. [The brief was not copied to FSA's conduct of business staff.]
The Treasury's Debt Management Office wrote to the Treasury's insurance division about the possibility of issuing a gilt, including an option designed to cover potential GAR option liabilities, if there were policy reasons making that desirable. They said that the suggestion had been put to them by a clearing bank. The Treasury's insurance division asked GAD for advice.
26/10/98
The Treasury's insurance division received oral legal advice from Treasury Advisory Division (Treasury's legal advisers) on the draft industry guidance.
The Treasury's insurance division sent the then Economic Secretary proposed guidance to the industry on methods the Treasury considered acceptable for meeting the costs of GAR options. These were that policyholders could be expected to pay some charge towards the cost of their guarantees, but that where the full cost could not be recovered from such charges, it might be appropriate to meet the costs from surpluses within policyholders' funds. The note added that Equitable's approach of reducing the terminal bonus had been criticised in the press but was in line with the proposed guidance. It was reasonable that with-profit policyholders, who stood to gain from the sale of contracts containing GARs, should share any associated losses. A response by 30/10/98 was requested. [The draft was copied to GAD but not to FSA's conduct of business division or PIA.]
30/10/98
Equitable told GAD that the GAR would provide a higher level of income in around 30% of retirement cases, but that so far no clients had chosen to take advantage of the GAR. [Note: Equitable's practice of reducing the terminal bonus for policyholders opting for the guaranteed rate would usually negate the benefit of the GAR.] Assuming the worst case scenario would require a reserve of £170m. However, they felt it prudent to reserve on the assumption that 30% of policyholders would exercise the GAR option, which would in itself represent a significant shift in policyholder behaviour. Equitable said that the commercial cost of the guaranteed annuities was highly unlikely to exceed £50m. To assume the most prudent approach (and reserve at £170m) would mean reserving at least three to four times the expected true commercial cost and, probably, a substantially higher multiple than that. Equitable felt that that would be inappropriate.
02/11/98
The Treasury's insurance division told their Debt Management Office that they were monitoring very closely the exposure of companies to the GAR issue. They considered that the bank which had raised the question of a gilt (19/10/98) was somewhat overstating both the size of the problem and the difficulties posed for companies, but concluded that it was early days yet, and they would get back to them if their involvement was thought necessary.
03/11/98
GAD passed Equitable's letter of 30/10/98 the to Treasury's insurance division saying that it was not acceptable for Equitable to rely on the terminal bonus, for which they had made no provision, to meet the cost of the GARs. Equitable had not yet recognised that, nor had they attempted to quantify the reserves on the basis requested at the meeting held on 2/10/98. GAD said that the issue of adequate mathematical reserves was quite separate from that of applying GARs consistently with policyholders' reasonable expectations. Mathematical reserves needed to reflect the full value of the GARs; Equitable should reserve on that basis. That was necessary to comply with Regulation 64 of the Insurance Companies Regulations 1994. If Equitable were unable to meet that obligation, then intervention under section 37 or section 11 of the Insurance Companies Act 1982 might be warranted. GAD advised that the Treasury's insurance division should write to Equitable urgently inviting them to a meeting in the next few days to explain how they proposed to fund the mathematical reserves that were required.
c04/11/98
The Treasury's insurance division decided that an urgent meeting with Equitable was required to satisfy themselves that: Equitable were taking a proper view of their liabilities, not only the actuarial issues but also contractual rights; that Equitable had not cherry picked the policy and promotional documents provided so far; and to take a view on whether Equitable's approach was in line with the Insurance Companies Act requirements and more generally accorded with policyholders' reasonable expectations. They noted that it might be necessary for the Treasury to seek Counsel's opinion.
05/11/98
The Treasury's insurance division sent the FSA the draft guidance letter of 26/10/98 on how they expected companies to meet policyholders' reasonable expectations in dealing with GARs and the costs of meeting them. The Treasury drew attention to Equitable's "controversial policy" of paying the GAR on the guaranteed sum and not on the terminal bonus. They said that their preliminary view was that Equitable were entitled to do this, but they were seeking further information to test the position further. Their primary concern, however, was over Equitable's ability to reserve adequately for these guarantees. They commented: "The information received to date is unconvincing and raises serious questions about the company's [regulatory] solvency." The Treasury said that they were meeting Equitable again the following week to discuss what further steps they might require Equitable to take.
A copy of this note was sent to the FSA's conduct of business director who endorsed it on to a senior colleague saying "Are we clear that PIA has no standing in this, because the business was written pre the coming into force of the '86 Act?" The recipient passed the note to another colleague saying that was also his understanding of the position.
The Treasury's insurance division wrote to Equitable noting a wide discrepancy between their views on Equitable's approach to reserving for GARs. They said that in accordance with Regulation 64 appropriate mathematical reserves had to be established for the full value of the GARs. Equitable had not even attempted, as requested on 02/10/98, to quantify the reserves on that basis. An urgent meeting, to be held at the Treasury, was required. After that discussion, the Treasury would write again setting out more fully what further steps they might require Equitable to take. The meeting would also offer an opportunity to discuss further the issue of policyholders' reasonable expectations arising from Equitable's treatment of GARs.
06/11/98
FSA's chairman wrote to the director of the Treasury's insurance division to ask for advice about questions which had been put to him about GARs, and Equitable's approach. These included whether Equitable were right in their view that they could fund a guarantee by reducing bonuses or whether that inappropriate and the regulators should outlaw it?; whether there had been a failure of prudential supervision if the with-profits fund could not bear the cost of these guarantees; and what would happen if the funds were not available to pay up except by reducing the size of the fund below a level which actuaries felt was required to deal with other policyholders' reasonable expectations. Would not regulators then be invited to "pay Peter by robbing Paul", and how would the decision be made?
A copy of the memo went to the conduct of business division where a manuscript note was made on it, which said that the division did not think these were matters for them.
09/11/98
FSA's managing director told the Treasury's insurance division that in his view it was "critical" that they sought further information to test their preliminary view of 05/11/98, that Equitable were entitled to pay the GAR only on the guaranteed sum and not the terminal bonus.
11/11/98
Equitable apologised to the Treasury's insurance division for misinterpreting their request for additional information. They said that the basic additional reserve at 31/12/97, on the basis requested, would have been c£675m; projected to 31/12/98 at a valuation interest rate of 5% the basic additional reserve would have risen to £1,375m. However, it was difficult to assess the impact of future premiums [i.e. of top-up payments] as it would mean scanning the files at the year-end to determine where entitlement to pay further premiums existed (contractually entitlement was lost if a premium was not paid each year).
The Treasury's insurance division asked GAD to suggest what information they might ask Equitable to provide to satisfy themselves of the reasonableness of Equitable's actions in terms of policyholders' reasonable expectations.
12/11/98
An internal minute within FSA's conduct of business division commented on the chairman's note of 06/11/98 to the director of the Treasury's insurance division. They said that there were marketing as well as prudential aspects to the issue. PIA had not formed a view on the Equitable case. However experience of with-profit cases had shown that it was difficult to prove a complaint that would restrict a firm's flexibility in the way it declared bonuses. The author had not seen the wording of Equitable's policies which would clearly be significant. Nevertheless, while Equitable might properly be able to reduce bonuses, they were acting in poor faith in doing so.
GAD briefed the Treasury's insurance division to ask Equitable for any material supporting the adoption by Equitable's board of a
two-tier terminal bonus system as a modification of policyholders' previous expectations.
13/11/98
The Treasury's insurance division, their legal advisers and GAD met Equitable to discuss GAR options and the implications for policyholders' reasonable expectations of Equitable's treatment of policyholders with such options. The Treasury's insurance division said that Equitable's policy of reducing terminal bonuses for policyholders with GAR options that were biting was a high profile industry issue. Equitable said that Counsel had endorsed their position and concluded that their directors had not used their powers improperly. They agreed to provide the Treasury with a copy of Counsel's opinion and supporting materials. The Treasury's insurance division said that projections to policyholders with GAR options had apparently shown the GAR applied to the unadjusted terminal bonus; Equitable said that even if that were the case, the level of terminal bonus had not been guaranteed. The Treasury's insurance division asked for information to allow them properly to understand what impression had been given to policyholders over the years. Equitable said that their sales force covered the GAR option in their dialogue with policyholders only if it was more attractive to the policyholder. The Treasury asked for a list of policy numbers that had matured in the last three years. They would then select a sample of maturing policies at random and examine them. They again told Equitable that they should reserve for what was payable under the contract, arguing it was a statutory requirement and they expected Equitable to reserve on that basis [their emphasis]. Equitable said that the timing of any additional reserving was a critical issue. There would be severe commercial implications from reporting low solvency cover, but they were convinced the company would remain solvent. Equitable said that they were considering applying for a section 68 order with respect to the resilience calculation which would assume only 50% of policyholders took the GAR option. They agreed that they would need to think about reducing bonus declarations, but said it was impractical to think that they could slash them harshly without serious implications for public relations. (FSA's conduct of business division were not represented at the meeting.)
[According to the Baird report, Equitable's exposure to top-ups (whereby some policyholders were entitled to pay additional premiums at any time and any GARs applicable to the policy in question would attach equally to those additional payments, and which were referred to in Equitable's response to the GAD survey - see entry for 29/7/98) was also considered at this meeting, but I have seen no evidence of this.]
16/11/98
GAD told the Treasury's insurance division that, if differential terminal bonuses were permissible under the policy wording, then they seemed to be legally acceptable. Equitable might be open to policyholder complaints, but GAD did not believe that the Treasury could raise objections. Equitable had told GAD about the possibility of their applying this practice in their 1993 regulatory returns, but had first told policyholders in a bonus notice issued in January 1996. Equitable were reluctant to grant to GAR policyholders bonuses materially in excess of their asset shares, to the detriment of other policyholders. However there was still the question of whether their practice was consistent with policyholder expectations. GAD expected that early marketing literature would not have covered the possibility and Equitable were relying on their general discretion and accordingly remained open to legal challenge. GAD remained convinced that full reserves for guaranteed annuities should be carried.
The Treasury's insurance division wrote to Equitable asking for copies of literature given to policyholders and of Counsel's opinion. They also expressed concern that where the GAR option was biting to the extent that there would be no terminal bonus if the GAR option was exercised, the policyholder would receive lower benefits if choosing the cash option. The specimen contract provided prior to the 02/10/98 meeting could be interpreted as entitling the policyholder to cash to the same value as the GAR option in such cases. They repeated that Equitable were obliged to reserve on the basis that the GAR options would be exercised in 100% of cases, if more valuable than current annuity rates. The Treasury's insurance division said that they recognised that that could have a significant impact on Equitable's financial position. They asked for the latest estimates of free assets and solvency cover and for the latest management accounts. [The letter was copied to GAD but not to FSA's conduct of business division.]
18/11/98
Equitable sent a holding reply to the Treasury's insurance division, adding that surplus assets and implicit items before reserving for GAR options were around £2bn.
19/11/98
The then Economic Secretary, who was not content with the proposed guidance sent to her on 26/10/98, commented that if people had bought a contract it was a guarantee and they should not subsequently be expected to pay for the guarantee themselves. She questioned whether shareholders should bear some or all of the costs involved, also whether use could be made of free estate where it existed. [Neither point was in fact relevant in Equitable's case because they had no shareholders and no free estate to speak of due to their policy of full distribution to their policyholders.]
23/11/98
Equitable sent the Treasury's insurance division a full reply to their letter of 16/11/98 including: policyholder literature, illustrations of when the GAR option would and would not produce higher retirement income, and a copy of Counsel's opinion. Counsel gave the opinion that Equitable were "justified in law" in adopting the approach of declaring differential final bonuses in order to ensure (so far as was possible having regard to the operation of guaranteed annuities on previously guaranteed values) that the ultimate cash value of any given policy would be a single sum, irrespective of whether the policyholder took the guaranteed benefits under his policy or elected to take an alternative annuity based on application of the current annuity rate. Counsel added that the top-up element would be allocated by the Board exercising its discretion under article 65 (see 01/10/98), which was wide enough to enable bonuses to be allocated among members in top-up form as well as in annual and terminal form.
The Treasury's insurance division circulated counsel's opinion to their legal advisers and to GAD for comment.24/11/98
Equitable wrote to GAD, who copied the letter to the Treasury's insurance division and legal advisers. It was Equitable's view that since 1993 GAD had tacitly accepted their approach to reserving. [See also the entry for 04/01/99 below.] They could not see why, in the face of logic and practical experience, prudence necessitated assuming that 100% of benefits would be taken in the most onerous form. Equitable's auditors were said to support their position. Surplus assets at 30 October 1998 were £1,164m and they had a section 68 order allowing implicit items of up to £850m to be brought into account. Equitable argued against GAD's position, saying that the choices available, if onerous reserving were to be required, included declaring no bonus. If Equitable gave way to pressure to adopt an excessively prudent and over-cautious reserving basis, the consequences for the company were potentially extremely serious. Equitable said they would need to consider what steps to take in terms of consulting with the [actuarial] profession; informal soundings indicated they were not alone in their interpretation of Regulation 64.
Guidance note DAA10, from the Government Actuary, amended the guidelines for resilience test 2. The note 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.
GAD provided the Treasury's insurance division with a note intended to assist them in explaining their position more fully to the then Economic Secretary. They noted the difficulty for insurers such as Equitable, for whom the residual cost of the guarantee was relatively high, with no shareholders or free estate and where the guarantees fell to be met by either the beneficiaries or the remaining policyholders.
A manuscript note by the Treasury's insurance division said that it was important to be clear that there was no one right answer and that different solutions were possible, each of them fair.
25/11/98
GAD sent the Treasury's insurance division in confidence a report of the results of their survey which they had prepared in September. They pointed out, however, that the situation had moved on, as they were in the process of interviewing the worst affected companies and so the detailed information was now out of date. They said the quality of the survey responses had not been sufficiently rigorous for them to draw conclusions about the 74 individual companies and that the report should therefore be interpreted as giving only a general overview. The survey suggested that while most guarantee schemes were "in the money", some were not. Applying a minimum reserving standard of a prudent mortality rate, 4.5% interest and 2% for expenses, they believed that the industry would need to establish additional reserves of some £10bn, which did not include any allowance for costs arising from the receipt of future premiums under contracts with GAR options. Equitable seemed to be particularly vulnerable. Across all companies at the end of 1997 there may have been an unrecognised liability of some £3bn, around half of which related to Equitable, who could be technically insolvent [regulatory insolvency was intended]. The issue of annuity guarantees would be raised with each company as part of the scrutiny process for their regulatory returns. GAD stressed, however, that their methodology was open to question, as an annuity basis suitable to the whole population was likely to be unsuitable for a given product line. Most insurers writing with-profits business were considering carefully whether to reduce the final bonus to policyholders with GAR options; the practice was being followed by eight companies, including Equitable. Seven companies, including Equitable, did not inform policyholders about the existence of GAR options.
26/11/98
An updating note prepared by the Treasury's insurance division about the effect of current market conditions on life insurers noted that Equitable were one of four companies facing serious difficulties. Equitable were just covering the required minimum margin if all policyholders exercised their GAR options. Publication of such a low solvency position was likely severely to undermine their reputation and could threaten their survival as an independent entity. Discussions were continuing about the reserving basis to be used and Equitable's approach to charging policyholders for the cost of GAR options.
01/12/98
GAD reviewed the legal advice Equitable had sent on 23/11/98 and told the Treasury's insurance division that in their view the advice did not wholeheartedly support the actions Equitable had taken thus far. As they saw it the documentation to date had not adequately described the bonus methodology Equitable were adopting. Counsel had said, and GAD agreed, that the policy wording required Equitable to allocate the terminal bonus before the policyholder decided which benefit to take. However the legal advice to Equitable was that a differential terminal bonus could be applied under [article 65] requiring Equitable to declare a lower terminal bonus to GAR policyholders, with a bonus for those not taking the GAR option. It was possible that past policyholders whose policies had matured could successfully argue they had not been treated fairly. The Treasury's insurance division had also noted a risk that Equitable could be liable to pay the guarantee on top of the full fund, with a need for an appropriate provision. (An officer of FSA's prudential division commented in manuscript "i.e. need to reserve on basis that Eq Life might lose in Court.")
GAD wrote to the Treasury's insurance division about reserving saying that, under Regulation 64, policy valuation had to take account of all prospective liabilities, including guaranteed annuities. Equitable needed to have sufficient assets now to cover the final bonus that might be payable in lieu of the GAR option benefits. If Equitable reserved in full for 100% of benefits in GAR form, they would just have sufficient cover for their required margin of solvency as at 30/10/98. While this might not suit them commercially, it indicated that they were very reliant on future surpluses to fund future bonuses, including terminal bonuses. It was difficult to see how Equitable could justify declaring any bonus at the year-end. In the medium term they would need to look for some ongoing form of capital support if they were to remain viable under difficult investment and trading conditions.
02/12/98
The Treasury's legal advisers gave their insurance division interim advice on Counsel's opinion provided by Equitable on 23/11/98. They said that they found it hard to take issue with the opinion, although they noted that that had been given in the context of contract and trust law. They said that they understood the insurance division to be of the view that consideration of policyholders' reasonable expectations might go beyond that; were that to be the case, the opinion would not be an end to the matter. They said that the insurance division would want to reach their own view on policyholders' reasonable expectations. On the question of reserving, Regulation 64 was very wide and it was for the courts, not the Treasury, to decide if liabilities had been properly determined. There was room for more than one reasonable view of proper provision and prudent assumptions, though any entity adopting the Treasury's and GAD's view on reserving would be within Regulation 64. It was not clear, however, whether Equitable's view was in breach of Regulation 64; it would probably be for the Treasury to show a breach, not for Equitable to show compliance. If Equitable were not in breach, then the legal advisers were not clear on what basis the Treasury might take action against Equitable.
FSA's conduct of business division circulated a note to their managers on recent press articles about Equitable and other firms who had offered GAR options. They said that this might become a big issue affecting a large number of firms and costs of billions of pounds. There was speculation that mutuals might find it hard to survive if they had to honour GARs. FSA's conduct of business division commented on the difference in approach between prudential regulation, focusing on a firm's ability to stay in business, and conduct of business regulation, looking at what the firm had promised investors and whether they should be liable to pay the maximum figures. They said that they had been in touch with the Treasury's insurance division who were looking at the position, particularly with regard to Equitable's regulatory solvency, if the guarantees were enforceable. The insurance division were also reviewing Equitable's literature (policies and bonus notices) to enable them to take a view about what reasonable expectations a policyholder might have had from reading it.
03/12/98
The Treasury's insurance division and GAD met Equitable and told them that, in their view, there was at least a possibility that dissident policyholders seeking a GAR option on an unadjusted terminal bonus might win a case in court. Equitable admitted that that was at least a potential contingent liability. GAD denied Equitable's assertions that for several years they had tacitly accepted Equitable's approach. They said that they were aware from their regulatory returns that Equitable had written GAR option business, but not the construction of the contracts or the reserving basis. The Treasury said that they saw no scope for concessions on reserving. Equitable expressed concern that they were being forced to adopt a "wildly prudent" reserving approach, bearing no resemblance to commercial reality, and damaging to policyholders. On being told that there was no appeal other than by way of judicial review, Equitable said that they might well have to take up that option. They did not expect the policyholders' action group to bring legal action in the near future. Equitable said that they had considered reinsurance as an option to protect the balance sheet, but were reluctant to broadcast their position to potential reinsurers while they were still hoping the regulatory position might change. Even if reinsurance was purchased it was unlikely to be in place that year. The Treasury said they thought it would be possible to give a post-dated concession to cover the 1998 year end. However, they still had some way to go before coming to a conclusion about the reasonable expectations of Equitable's asset share treatment for policyholders with biting GAR options. The Treasury were concerned about whether policyholders' reasonable expectations had been met for policies that had already matured, and they gave Equitable details of the further material that they wished to see in relation to this.
04/12/98
The Treasury's legal advisers gave their insurance division further interim legal advice on the reserving issue. They said that, on balance, a court was likely to accept that Equitable's position was untenable, though they were not convinced that a court would accept that Regulation 64 required reserves to be made on the assumption of 100% take-up of GAR options. A court would be likely, however, to accept that 100% or thereabouts was required in this case if Equitable continued to maintain their position that a much lower rate could reasonably be assumed. Action to be taken if Equitable "did not come quietly" [which I presume meant if Equitable did not accept GAD's view on reserving levels for GARs] could include pursuing them for breach of section 45 (see paragraph 34) on the grounds that the criteria of sound and prudent management were not being met. Such intervention was unlikely to be successfully challenged in the courts. However, the onus rested on the Treasury to show that Equitable had breached the regulatory requirement. The legal advisers said that they still found it hard to take issue with Equitable's Counsel's advice in respect of the differential terminal bonus practice, although they reiterated their comments regarding the context in which that advice had been given [see 02/12/98].
07/12/98
The Treasury's insurance division sent Equitable a note of the main points of the 03/12/98 meeting. It said that Regulation 64 pointed to assuming that 100% of policyholders took their benefits in GAR form. To the extent that Regulation 64 could be disapplied by a section 68 order, the Treasury would not be inclined to make such an order. They rebutted the arguments on reserving advanced by Equitable and said that they did not accept that an assumed GAR option take-up rate of 35% was prudent, nor that a reserve based on the cash option should exclude a terminal bonus. Treasury's insurance division agreed to consider the possibility of any reinsurance arrangement as having been effective from the year end, provided that at least the broad terms of the agreement were in place by that date and a firm intention to enter into the agreement could be shown. They added that, if Counsel's advice was followed, there was little doubt that policyholders' reasonable expectations would be met in future, but they questioned whether they had been met in those cases where policies had already matured. They concluded that they expected to see in Equitable's regulatory returns an appropriate statement on contingent liabilities, related to the risk of successful challenge to Equitable's bonus practice for GARs.
08/12/98
GAD told the Treasury's insurance division that an alternative valuation basis for GAR contracts could satisfy Regulation 64. It could be reasonable to assume that less than 100% of policyholders would elect to take the GAR, provided that the reserve held in respect of those assumed to take an alternative form of benefit was based on a realistic value of that alternative. They suggested a formula for calculating this and said that while it might be prudent in Equitable's case to assume that only 50% of policyholders were to choose the GAR option, the value of the alternative option should be not less than 95% of the liability arising if the guaranteed benefit were selected. GAD said that they had no objection to Equitable being permitted to phase in the new formula over a reasonably short period of time, subject to their providing assurance that the phasing in would be completed before significant liabilities began to arise. They also recommended that the Treasury's insurance division seek some commitment from Equitable to reduce the declared reversionary bonus until full provision for the GAR liabilities had been made. GAD added that Equitable's reply to the survey of 29/07/98 had disclosed their significant exposure to GAR options. GAD offered to discuss Equitable's approach with the appointed actuary.
In an internal note (not copied to the prudential division) FSA's conduct of business division commented that the relevant annuities had all been sold before the Financial Services Act 1986 came into force and so were probably not caught by PIA rules. However, if Equitable should have provided for paying the GAR and full terminal bonus but had not, and had therefore been able to offer investors returns in recent years more generous than they would otherwise have been able to, then that now enabled them effectively to inflate past performance figures. FSA's conduct of business division decided, before taking any action, to await the outcome of the Treasury's insurance division's review of how Equitable were interpreting their obligations against the test of policyholders' reasonable expectations. Any action would need to be taken working closely with the Treasury's insurance division.
09/12/98
The Treasury's insurance division gave the then Economic Secretary more background to the proposed further guidance letter on policyholders' reasonable expectations, including a fuller justification for the lower final bonus, and again sought approval. They said that the particular difficulty for Equitable was that guarantees had either to be met by the benefiting policyholders, or spread across all with-profit policyholders who shared in the overall profits and losses of the relevant business. As Equitable had approximately 25% of its with-profits business affected by GARs, and the level of guarantee was high, the impact on the total amount of bonuses payable was relatively large. Equitable were charging the residual costs of the GAR options to the beneficiaries by reduced final bonus. Contractually it was arguable whether they were obliged to spread the cost more evenly across all policyholders and the Treasury were seeking more information about that. There would be no failure of policyholders' reasonable expectations where an insurer had an asset share policy that had been clearly communicated.
10/12/98
Equitable told the Treasury's insurance division that they did not accept the Treasury's view of what constituted a prudent reserve; in the light of favourable legal advice they had received, they were willing to challenge any use of FSA powers through judicial review. Equitable said that they were also pursuing the possibility of reinsurance and wished to meet with the Treasury's insurance division again shortly.
The head of the prudential division said, in a personal file note, that Equitable must reserve on the basis of the contract and must cover all guaranteed annuities. The consequences for Equitable were serious but needed to be faced now. Referring to policyholders' reasonable expectations, he said that it was at least arguable that they should pay guaranteed annuities on the 'full' final sum as the literature implied this. There was a risk of needing to reserve for higher payments for 1994-98, and a need to make an appropriate reference to contingent liability in the regulatory returns. At 25% above current rates, Equitable [GAR] policyholders would find cash commutation attractive across a wider range of economic conditions than other companies.
11/12/98
The Treasury's legal advisers told their insurance division that there was no provision to require a company to reissue or amend accounts when it had breached Regulation 64. They expressed the belief that a court would expect the Treasury's insurance division to prosecute a clear breach of the Insurance Companies (Accounts and Statements) Regulations 1996 [which prescribe the form and content of the annual returns that companies are required to submit] or to act under section 45 of the Insurance Companies Act (paragraph 34) if they considered Regulation 64 insufficient in a particular case. They said that a decision to intervene to direct that past published accounts should be corrected would have to be supported by good grounds.
c15/12/98
In preparation for handing over prudential regulation to FSA, the Treasury's insurance division briefed FSA's chairman and the managing director on their current views on Equitable's position. Equitable proposed to reserve for 25% of GAR options which meant free assets of £2,452m; the Treasury said that, if Equitable reserved for 100% of GAR options, their free assets would then only be £220m and insufficient to declare a bonus, the cost of which, assuming they maintained the current level, would be £500m. The Treasury's view was that they must reserve at or close to 100% for GAR options. This was because Equitable were effectively having to guarantee to pay terminal bonuses to GAR option policyholders at a level which made the cash option worth as much as the GAR option; accordingly they should reserve for what was effectively a guaranteed benefit. The Treasury said that they were not minded to act for failure to reserve fully for GAR options in the 1997 returns (which would be consistent with the approach taken with other companies) but Equitable would be formally told that FSA would intervene if the 1998 returns did not comply. Intervention, which would be likely to be in terms of closing the company to new business, would follow if Equitable either declared a further bonus without prior discussion with the Treasury, or declared a bonus that would breach its required minimum margin if GAR options were fully reserved. They concluded that Equitable could be expected to seek judicial review of any intervention action in relation to reserving for GAR options.
15/12/98
The Treasury's insurance division and FSA's chairman and relevant managing director met for a briefing on issues relating to Equitable, including the draft guidance on the reserving standards required. FSA queried the nature of the future profits that could be taken into account to cover a company's solvency margin. The Treasury explained that only future profits on business already written, and only a conservative estimate of that, was allowed in the returns. As to the fact that no action had been taken against Equitable in respect of their 1997 returns, FSA's managing director said that he considered it defensible for the Treasury to change their view as the picture filled out and the significance of GARs changed. It was considered that Equitable's Counsel's opinion provided reasonable comfort that their approach of reducing terminal bonuses to meet the cost of the GAR was consistent with policyholders' reasonable expectations. The Treasury went on to say that, assuming 100% reserving for GAR options was necessary, Equitable should not be permitted to make itself insolvent [in a regulatory sense] by declaring further bonuses - but they also acknowledged that not to declare a bonus would be very damaging commercially; the chairman was reported to have said that for Equitable to be forced to pass a bonus would amount to commercial suicide. The Treasury added that they had had discussions with several other companies which had accepted that GAR options had to be fully reserved.
FSA's chairman was concerned that the Treasury's approach should be defensible in view of the risk of judicial review; the proposed guidance letter (on reserving policy) would be helpful. FSA's managing director expressed concern that any relaxation in the Treasury's position on reserving levels for GAR options would undermine their position, as any level below 100% was necessarily arbitrary. He was also concerned that the Treasury did not appear to have solid support for their position from GAD. The Treasury said that GAD were considering a relaxation of the reserving requirement to 97.5%. It was suggested that Equitable, or another company acting in response to guidance that the Treasury proposed to issue on the required level of reserving, might seek judicial review of their position. It was felt however that, even if that were to happen, it would not block any action that the Treasury might wish to take against Equitable in the meantime. A move by the Treasury to prevent Equitable declaring a bonus could be justified as action to prevent a breach of the criteria of sound and prudent management, and so should be outside the immediate scope of any judicial review. FSA's chairman said that Equitable might prefer seeking a buyer to judicial review. It was agreed that a takeover would not be a good result for the company or for the Treasury. The chairman considered it important to understand the sensitivity of the financial positions of Equitable and others to movements in gilt yields; the Treasury said that they would assess this further. It was noted that Equitable had reported little contact with the policyholders' action group and had received few complaints. The Treasury told FSA that, importantly, the financial position would not be made worse (assuming it had already reserved at 100%) if Equitable had to abandon the approach of reducing the terminal bonus paid to policyholders exercising the GAR option. The only additional cost would be topping up payouts that had already been made to policyholders. FSA agreed that the Treasury appeared to be taking the only sensible approach.
15/12/98
GAD told the Treasury's legal advisers and the Treasury's insurance division that they did not agree there were no grounds to require a company to amend or reissue accounts that breached Regulation 64 and pointed to sections in the 1982 Act which they believed did give the Treasury that power.
Following the fuller justification of 09/12/98, the then Economic Secretary agreed the draft guidance letter to insurers first proposed by GAD on 09/10/98.
16/12/98
In reply to a complaint from a policyholder about Equitable's differential terminal bonus policy, the Treasury's insurance division said that guaranteed benefits did not normally extend to discretionary final bonuses. A number of insurers therefore considered that the level of discretionary bonus might be adjusted to ensure fairness between policyholders. Such an adjustment was particularly relevant for mutual insurers, who would find it difficult to provide additional amounts of discretionary bonus beyond the value of the accumulated premiums attributable to the policyholders in question, without prejudicing the interests of other policyholders. The Treasury believed that they were treating all mutual insurers in a similar manner.
Equitable's Board resolved to initiate a test case in the courts to determine whether they had the right to declare differential terminal bonuses.
17/12/98
The Treasury's insurance division sent the draft guidance (on the principles which life insurers should follow in determining how to handle GAR options in the context of policyholders' reasonable expectations) to FSA's managing director. They said that, while the letter set out general principles, which were intended to ensure a consistent and fair approach overall, some commentators were likely to see it as relating primarily to Equitable.
Equitable sent the Treasury's insurance division some of the documentation requested at the meeting on 03/12/98.
18/12/98
The Treasury's insurance division issued to life companies their guidance letter (DD1998/5) on policyholders' reasonable expectations. They said that policyholders with GAR options could expect to pay some premium towards the cost of those options. They considered that, generally, it would be appropriate for the level of charge to reflect the perceived value of the guarantee over the duration of the contract. That could be achieved in some cases by a reduction in the terminal bonus added at maturity, though the approach to be taken by each company would depend on the wording of the contract involved and how it had been presented to policyholders. They said that each company would have to assess the appropriateness of such adjustments to bonus allocations in the context of the reasonable expectations of all policyholders; that assessment would be influenced by the policy documents and any representation made through marketing literature, bonus statements or elsewhere. The guidance was given without prejudice to any decision of the courts.
Equitable sent the Treasury's insurance division joint leading Counsels' opinion, which said that the Treasury's requirement for reserving was manifestly unfair and open to judicial review as in breach of Equitable's legitimate expectations, and also ran contrary to policyholders' reasonable expectations as it would lead to a reduction in future bonus payments. Equitable said that they had decided, on leading Counsel's advice, to initiate a test case in the High Court to confirm that their directors had acted properly and within their powers on their practice on terminal bonuses. (A Treasury officer's manuscript marginal notes commented that they had not been aware that GARs had exceeded current annuity rates to any significant extent from 1994 onwards, and that they had acted as soon as they had become aware of the situation.)
GAD told the Treasury's insurance division that at the meeting on 28/05/98 they had urged Equitable to exercise great restraint in granting guaranteed bonuses. GAD did not accept that it would necessarily be commercial suicide for Equitable to grant no additional guaranteed bonuses that year on contracts containing GAR options, so long as the reasons were properly explained. Indeed, this was probably necessary for prudent management.
The Treasury service level agreement with FSA was signed. The Treasury contracted out to FSA responsibility for most aspects of prudential regulation (certain matters, such as the issue of section 68 orders could not be contracted out and were reserved to the Treasury).
late 12/98
The Treasury's insurance division received the remainder of the materials requested from Equitable on 03/12/98.
22/12/98
The Treasury's insurance division and GAD met Equitable to discuss the legal opinion of 18/12/98. The Treasury agreed to provide a formal response to the legal opinion as soon as possible. They commented that it was for Equitable to reserve as they saw fit, but that the Treasury would take regulatory action if reserves were inappropriate or if Equitable's actions imperilled solvency margin cover. They would act, for example, if bonus declarations were imprudent. Equitable agreed to liaise with the Treasury prior to deciding a bonus strategy, but did not guarantee not to pay further bonuses to policyholders with GAR options. They said that, although they were looking to reduce bonuses generally, it would be difficult not to give policyholders with GARs some bonus. Equitable repeated that they did not agree that the reserve should be 100% and that the regulatory regime did not require reserving for terminal bonuses, this was something the Treasury were suddenly applying.
The Treasury said that the terminal bonus was effectively guaranteed up to the value of the guaranteed annuity since if no terminal bonus was added, everyone would take the guaranteed annuity. For their part, GAD again [see 03/12/98] denied that they had tacitly accepted Equitable's past reserving practice for GAR options. They pointed out that the information disclosed in the return was limited and gave them no reason to question the validity of the reserving basis. They said that the actuarial working party had concluded that holding no reserve and assuming the cost of GAR options could be met from terminal bonus was imprudent. The Treasury said that 100% reserving was being required industry wide.
Equitable said that they accepted the need to put up a substantial reserve but still considered the level the Treasury required to be excessive. They said that reserving for the full amount of the guarantees would seriously constrain investment strategy, and low solvency would threaten the company's future. These combined could put immense pressure on them to find a buyer. They added that there were further margins in the reserving that could be released, giving them further free assets of approximately £200m; they could also apply for a section 68 order for a larger future profits implicit item up to £1.9bn. The Treasury acknowledged that they were likely to treat such an application sympathetically.
Equitable suggested that the blow could be softened by assuming that 30% of all relevant policyholders would take the guaranteed annuity, while reserving at 100% in respect of those policyholders closest to retirement. The Treasury said that they were sympathetic to that aim, as they understood the potential for policyholders to be adversely affected by a "sudden hit" of such magnitude and they agreed to consider any such proposal as an interim measure. Equitable concluded that they were actively discussing reinsuring the reserves for GARs.
Equitable applied for a revised [see 26/06/98] section 68 order for a future profits implicit item of £1.9bn, to be counted towards their solvency margin on 31 December 1998.
23/12/98
GAD told the Treasury's insurance division that they supported the application for a section 68 order.
31/12/98
The Treasury's legal advisers reaffirmed to GAD their view that there was no power as such to require reissue or amendment of accounts which breached Regulation 64. They also gave their insurance division a draft response to the legal opinion provided by Equitable on 18/12/98.
Equitable asked the Treasury's insurance division for a response to the legal opinion as promised at the 22/12/98 meeting. Equitable said that they had received an offer in respect of a financial reassurance arrangement from a reinsurer. Further information would be provided shortly after 07/01/99 "should we wish to proceed". Attachments sent with the letter included a copy of a fax dated 23/12/98 from the reinsurer saying that they were most interested in finalising a contract that would meet the needs of Equitable in respect of the issues discussed; it was hoped to resolve these to enable a contract to be drawn up to reflect the concept discussed. A manuscript endorsement by the Equitable recipient said: " ... this, apparently is the letter of intent, and we shall not be receiving anything else in writing before our meeting on 7 January". The costs would be: an annual premium of £50,000; in the event of a claim, 2% of the claim; repayment of any claim over about three years from earnings in excess of those required for the statutory valuation.
The Treasury granted Equitable's request for the section 68 order.
Equitable had over £28bn of investment funds under management, which included over £21bn in their with-profits business. The statutory reserves required for GARs were £1.6bn.
