Case No. C.1597/01para42 - 101
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| Chapters 42 - 103 | Background to the complaint |
| Chapters 104 - 167 | Further evidence & developments |
| Chapters 168- 238 | Chronology & conclusion |
Background to the complaint
Equitable
42. Equitable are the world's oldest mutual life assurance society. (In a mutual society like Equitable, the with-profits policyholders are also the society's members.) I understand that they were noted for the success of their sales force and the quality of their client base; they were also reputed to have advanced administration systems. Equitable had chosen to remain a mutual society and had a well-articulated and widely publicised policy of not holding back reserves, but allowing policyholders to follow the fortunes of the company. The Corley report (see paragraph 38) commented that Equitable were unusual, if not unique, amongst mutuals in not maintaining a free reserve or 'estate'. A notable feature of Equitable's portfolio of liabilities was the very high proportion represented by a single product range: the individual and group personal pension plans containing guaranteed annuity rate (GAR) options. The Corley report commented that "... [no] other UK life insurance companies granted to policyholders quite such advantageous terms ...". The lack of shareholders as a possible source of additional capital and the absence of any estate meant that, although sound, Equitable were - by design - not particularly strong financially. All of this information was in the public domain from Equitable's own information to policyholders, official returns and analyses published by commentators.
43.In 1957 Equitable began to introduce GARs on some with-profits policies, for many years offering a (flat rate) GAR of 4%. By 1975 this had increased to 7%, where it remained until Equitable ceased to offer GARs in June 1988. Although other companies also offered policies with GARs, Equitable were unusual in both the proportion of eligible policyholders (some 25% by value) and the generosity of the GARs offered. However, there were somewhat restrictive terms in many policies associated with the GAR option, for example in Equitable's case they could be taken only on a single life, not on joint lives, which many policyholders would be likely to view unfavourably. Equitable's GAR policies also offered greater flexibility as to retirement dates than did those of many of their competitors. No additional premium was charged for the GAR options, and Equitable did not set aside or reserve identifiable funds to provide for their maturity. The GARs were initially generally well below then current annuity rates. However, with the decline in interest rates in the 1990s, current annuity rates first fell below Equitable's 7% guaranteed rate in October 1993 and, in December 1993, Equitable introduced differential terminal bonuses to reduce the advantage the GAR would otherwise have conferred over policyholders who did not have a GAR option. Equitable believed that if they did not take such action, GAR policyholders would obtain more than their fair share of the relevant assets at the expense of those whose policies did not contain GARs. (A table at Appendix D demonstrates the increasing value of GARs to Equitable policyholders in the 1990s.)
44.Interest rates continued to fall, so that by mid-1995 Equitable's GAR rates consistently exceeded current annuity rates; (by mid-1997 this was true for most companies that had issued GAR policies). By September 1998, as general interest rates declined and began to fall significantly below the level of the guarantee, the value of the GARs for many Equitable policies had reached 30% above then current rates. Actuaries were also, as part of their regular reviews, further lightening mortality assumptions (that is, allowing for pensioners to live for longer than they had previously assumed). This had the effect of making Equitable's GAR options (where exercised) even more onerous, since they would need to pay the policyholder a larger annuity for longer than they had previously expected. (The GARs would have been calculated on the mortality assumptions prevailing at the point of calculation.)
45.In addition to GARs, there was a contractual yearly increase guarantee written into most of Equitable's relevant contracts of not less that 3½% each year irrespective of Equitable's investment performance. This was offset against any bonus declared for those policyholders (for example, the 5% bonus declared for 1998 was effectively a 1½ % bonus for these policyholders, net of the 3½% guarantee).
46.There was no statutory requirement placed on insurance companies to include GAR liabilities explicitly in the regulatory returns unless they were regarded as having a value attached to them although appointed actuaries were required to have regard to the existence of options when calculating their liabilities and setting reserves. That effectively meant that until interest rates fell below the level of the guarantee, GAR liabilities were not necessarily captured in the returns.
Summary of events
47.For the sake of clarity I give the following summary of the events described more fully in Appendix C. Although my investigation is limited to the actions of FSA as prudential regulator from 1 January 1999 onwards, the events leading up to that date provide essential background to what transpired in the relevant period. They are therefore included in some detail in Appendix C and this summary.
Events before 1 January 1999
48.Equitable first started selling policies with GAR options in 1957, and they ceased to offer them from June 1988. From 1994 onwards Equitable began to apply for - and be granted - section 68 orders permitting a proportion of future profits to be included as an implicit item in calculating their solvency margin (see paragraph 25). The first two orders, for years 1994 and 1995, were for £500m; these increased to £600m and £700m for 1996 and 1997 respectively. (The amounts actually used in the accounts increased from £250m to £371m in that period.)
49.In 1997 GAD gave Equitable's 1996 regulatory returns a priority rating of three (see paragraph 19) (up from four the previous year). In their scrutiny report, issued in December 1997, they commented that Equitable seemed vulnerable to any sustained stockmarket downturn because guaranteed bonuses included credit for asset appreciation. They concluded that, while Equitable had no immediate problems with meeting their regulatory financial requirements, it would be desirable for them to reduce their guaranteed bonus levels. In January 1998 GAD told Equitable that it might be necessary for them to hold reserves for anticipated final bonus additions. However, when GAD finally closed scrutiny of the 1996 returns in June 1998, they told the then prudential regulator that strengthening Equitable's reserves was unnecessary.
50.Meanwhile, since early 1997, the Faculty and Institute of Actuaries had turned their attention to the GAR issue (the fact that GAR rates were then generally exceeding annuity rates and therefore appearing in returns on a significant scale), and had set up a working party to review the matter and companies' practices. In late 1997 the working party reported that they were unable to recommend a single approach to reserving for GARs. They suggested however that adjusting terminal bonuses in response to guarantees (Equitable's approach) could be regarded as "unsound", because no explicit provision was being made for an explicit guarantee. In June 1998 GAD surveyed the approaches of life companies to reserving for GAR options. They found that seven other companies, from a cohort of 74, caused them serious concerns in terms of their reserving but that Equitable and one other company were notable exceptions to industry practice and were of particular concern in not holding substantial reserves to cover GAR liabilities and having only limited scope to raise funds to cover the liability.
51.In August 1998 GAD alerted the Treasury's insurance division to the increasing value of GARs resulting from lower interest rates and lighter mortality. They said that GARs were a significant problem in the industry both in terms of numbers and the threat they posed to solvency (i.e. meeting their regulatory financial requirements) and to policyholders' reasonable expectations. However, provided the contract allowed it, the terminal bonus could be restricted to keep down the cost of a GAR option (i.e. a differential terminal bonus could be used), but that would not justify lower reserving as the terminal bonus itself was not reserved for. In September 1998 GAD told the Treasury's insurance division that all companies should be asked to report on the procedures in place to ensure that guarantees were included in quotations, and that they should use complaints to trigger review visits. They added that a more proactive course of reviewing companies routinely would be too resource intensive to be practical, arguably a significant overreaction to the issue and open to criticism as a misuse of powers. Two weeks later they forwarded to the Treasury Equitable's survey reply, suggesting that they should explore the GAR issue further with them.
52.Over the subsequent months there was considerable debate amongst the Treasury, GAD and Equitable, both over whether Equitable's approach of providing differential terminal bonuses was acceptable practice, and over the reserves required in respect of GARs to maintain regulatory solvency. On the matter of the differential terminal bonuses, Equitable strongly maintained that their approach was fair to all their policyholders and produced a Counsel's opinion which confirmed that Equitable's actions were "justified in law" given the discretion provided to directors by the Society's articles and the policies with its members. GAD suggested to the Treasury's insurance division that there appeared to be some confusion within the industry over what was acceptable practice for charging policyholders for GAR options, and they needed to provide companies with guidance on their interpretation of policyholders' reasonable expectations (see paragraph 33) in respect of GAR policies. At the same time the Economic Secretary to the Treasury asked for information about Equitable's approach, as she had started to receive complaints about their differential terminal bonus policy. After further internal debate on the matter, when the Economic Secretary initially took the view that the complaints she had received were not without some merit, she eventually approved the guidance and the Treasury's insurance division issued it on 18 December 1998. The guidance said that, subject to any decision by the courts, GAR policyholders could expect to pay some premium towards the cost, perhaps by some reduction in the terminal bonus due on maturity [which was Equitable's practice]. What was acceptable in individual circumstances, however, would be dependent on the proper interpretation of contracts issued by individual companies. The guidance placed the onus on the management of each company to ensure that their policy was compatible with the terms of their contracts and their policyholders' reasonable expectations, that is, what they had been led to believe through representations made to them at the time the policies were sold and subsequently.
53.The reserving issue caused even greater debate throughout the same period. GAD referred Equitable to the outcome of the actuarial profession's working party (see paragraph 50) and insisted that it was a statutory requirement to reserve for what was potentially payable under the contract. Accordingly the company's reserves needed to reflect the full value (100%) of the GAR options available to policyholders (on the basis that policyholders could be expected to select the alternative cash option only while its value was maintained close to the value of the GAR). Equitable proposed to GAD that they should assume a GAR take-up rate of 25-35% in their reserving calculations. GAD warned Equitable that, if the company were unable to comply with the reserving requirement, regulatory intervention might result. Equitable, for their part, complained that their policy of adjusting the final bonuses of those taking a GAR option had been declared in their regulatory returns since those for 1993 and that, by failing to raise the issue earlier, GAD had tacitly accepted their approach for several years. However, under pressure from the Treasury's insurance division and GAD, Equitable subsequently agreed to revisit the need to reserve for GARs and to reassess solvency, but they objected that that could have severe consequences for them. They also agreed to consider reducing bonus declarations, but argued that cutting those drastically, as the regulator was urging them to do, was impractical without serious implications for public relations. They strongly contended that, if they gave way to regulatory pressure to adopt what they described as a "wildly prudent" reserving approach, which bore no resemblance to commercial reality and which was damaging to policyholders, that would have potentially very serious consequences. On being told that there was no appeal other than by way of judicial review, Equitable said that they might well have to take that option. (During that period Equitable also revealed that many GAR policyholders were entitled to pay further premiums to top-up their policies; this effectively meant that, although Equitable could make a reasonably prudent estimate of liabilities which could arise as a result of the payment of further premiums, they were unable to assess their full potential GAR liabilities with any degree of precision. Equitable said that they did not see this as a risk because of their differential terminal bonus policy.)
54.In November 1998 GAD reported to the Treasury's insurance division the overall results of their survey (see paragraph 50). They said that, while most schemes were 'in the money', some were not, and Equitable seemed particularly vulnerable. There was an unrecognised liability of some £3bn across the industry at the end of 1997, around half of which related to Equitable, who could be technically insolvent (i.e. unable to meet their regulatory financial requirements). However, an internal Treasury report the same month concluded that, if all policyholders exercised the GARs, Equitable would still just cover the required minimum margin (see paragraph 22); but that publication of such a low solvency position was likely severely to undermine their reputation and could threaten their independent survival.
55.In the meantime, Equitable continued to insist that they had a strong basis on which to resist GAD's position on reserving as excessively prudent, and the Treasury considered what action they could take if Equitable refused to accept the need to reserve in full for the GARs. Treasury's legal advisers said regulation 64 of the 1994 Regulations (see paragraph 23) was extremely wide and that 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. Further, the onus would probably be on the Treasury to show a breach, rather than on Equitable to demonstrate compliance. That said, if Equitable refused to accept GAD's view on reserving levels, the Treasury could pursue them using their powers under section 45 of the 1982 Act (see paragraph 34) on the grounds that Equitable were not meeting the requirements of sound and prudent management. Such intervention was unlikely to be successfully challenged in the courts.
56.The Treasury made it clear to Equitable that they were not prepared to change their position on the required reserving levels and certainly would not be inclined simply to make a section 68 order sufficient for Equitable to be able to counter Regulation 64. They agreed, however, to reconsider whether Equitable would meet the reserving requirement were they to enter into a reinsurance agreement (against a higher than expected GAR take-up), but, in line with standard practice, would accept such an agreement as having been effective from the year end only if Equitable could demonstrate that the broad terms of the agreement were in place and a firm intention to enter into an agreement had been shown before then. GAD reconfirmed to the Treasury their view that under Regulation 64 Equitable had no choice but to reserve in full for 100 per cent of the benefits available in GAR form. They said that if Equitable did so, they would just have sufficient cover for their required minimum margin as at 30October1998. It was therefore difficult to see how Equitable could justify declaring any bonus at the year-end. GAD also subsequently recommended to the Treasury that they should seek some commitment from Equitable to reduce the declared reversionary bonus until full provision for the GAR liabilities had been made.
57.In mid-December 1998, in preparation for handing over prudential regulation to FSA from 1 January 1999, the Treasury's insurance division briefed FSA senior management on their views on Equitable's position. They said that, if Equitable reserved fully for GAR options, their free assets (of £220m) were insufficient for them to declare a bonus that year. The Treasury said that they were not minded to take action against Equitable for failing to reserve fully in the 1997 returns, but would intervene if the 1998 returns did not comply. They would also intervene (by closing the company to new business) if Equitable either declared a further bonus without prior discussion with them, or declared a bonus which would breach the required minimum margin (see paragraph 22). If GAR options were fully reserved without the reinsurance agreement in place, Equitable would be close to breaching the required minimum margin. On 22December Equitable applied for a section 68 order for a future profits implicit item of £1.9bn to be counted as part of their solvency margin on 31December 1998, and they subsequently forwarded details of a proposed reinsurance agreement, which had been discussed with the Treasury on 3December. The Treasury granted the section 68 order on 31December; the following day operational responsibility for prudential regulation passed to FSA.
Events from 1 January 1999 onwards
58.On 4 January GAD told FSA's prudential division that they were seeking further information from Equitable in the light of which they would consider phasing in the higher reserving requirement (Equitable would require a £1.5bn reserve to cover GARs in full). On 13 January the Government Actuary issued guidance to all appointed actuaries reminding them of the need to make proper provision for GAR liabilities on prudent assumptions. On 15 January in response to complaints from their policyholders about the legitimacy of their differential terminal bonus policy relating to GAR policies, Equitable funded an action by a representative GAR policyholder, Mr Hyman, to put before the court the arguments against their differential bonus policy.
59.On 18 January the prudential division asked Equitable for more information about their reserves, assets and financial condition. On 21 January Equitable told the prudential division that they planned to declare a 5% annual reversionary bonus (down from 6.5% for 1997).They said that they had entered into a financial reinsurance arrangement with effect from 31 December 1998 at a cost of £150,000 per annum which would provide support to Equitable when more than 25% by value of the GAR business maturing in that year selected the GAR option. The next day FSA's prudential division recorded that Equitable were one of four companies giving cause for concern, and that it was questionable whether they would be able to declare a bonus that year. Based on the GAD estimate, Equitable were only just covering the required minimum margin at end-October 1998 without reinsurance, with £1.15bn available assets to cover a regulatory solvency margin of just under £1bn. Should the court case go against them, their position could become even more precarious (because the reinsurance could lapse in that event).
60.On 26 January Equitable provided the information the prudential division had requested on 18 January; the prudential division responded by asking for further information including sight of any bonus recommendations made to the Board in the previous 12 months. The same day the prudential division decided that they preferred not to continue earlier efforts to reach a view on policyholders' reasonable expectations until after the conclusion of the court case as, although it would not preclude FSA from taking a view on whether Equitable's policy was consistent with policyholders' reasonable expectations and the possible need for intervention, the court's judgment on whether or not those expectations had been met would be sure to influence FSA's view.
61.On 27 January GAD raised a number of concerns with the prudential division about the reinsurance arrangements, including the fact that the draft reinsurance agreement could be cancelled retroactively if Equitable changed their practice on GAR options (which GAD presumed included Equitable losing their court case). Those concerns prompted a meeting between Equitable, GAD and the prudential division the next day to discuss the matter, which resulted in Equitable being asked to seek various revisions from the reinsurer. On 29 January GAD commented on the Board papers Equitable had forwarded relating to their proposed bonus declaration. GAD said that, while the financial position shown was likely to appear reasonably satisfactory, Equitable would be potentially close to regulatory action for failure to maintain the required minimum margin if the reinsurance were not completed satisfactorily. While, therefore, it would be difficult for FSA to object formally to what Equitable were proposing, they would need to monitor Equitable's position carefully. GAD commented that both they and FSA should voice their concerns to Equitable about their vulnerability and ask them to produce some contingency plans to show how they would react to adverse investment conditions. GAD also pointed out that Equitable continued to issue annual notices to policyholders showing a high level of projected benefits and thereby generating further expectations.
62.The prudential division immediately wrote to Equitable (on 1 February) on the lines suggested by GAD, underlining the fact that, in the absence of a robust reinsurance agreement, it would not be prudent to declare any bonus for 1998. They concluded, however, that were the reinsurance agreement to be revised to resolve GAD's concerns, they were not minded to object to the proposed bonus declaration. Two weeks later Equitable sent the prudential division a copy of the revised draft reinsurance terms, which led to both the prudential division and GAD raising further matters on it. On 22 February GAD confirmed to Equitable that they would accept the principle of the reinsurance offsetting GAR liabilities as set out in the terms of the agreement (paragraph 59), but added that they still needed to see the final version of the agreement.
63.On 24 February, however, FSA's prudential division raised with Equitable concerns of a different nature, namely that their 1997 regulatory returns might have given potential policyholders a misleading impression about Equitable's financial position. Equitable were asked to agree by 3 March to submit the 1998 returns by 31 March 1999 or face possible regulatory action. (FSA took the same action in respect of several other life assurance companies who had sold GAR policies.)
64.Equitable were not specifically mentioned at the first quarterly meeting between the Treasury and FSA's prudential division on 10 March. The following week, the relevant FSA managing director told the FSA Board about Equitable's particular difficulties. On 19 March the prudential division summarised the position of the six companies identified as being potentially at risk from GAR options and whose statutory solvency could be threatened if economic conditions were to deteriorate. Of those six, Equitable were viewed as giving rise to the greatest concern as their financial position had been very severely affected. The prudential division said that, despite action taken to restore Equitable's solvency margin to a more acceptable level, they remained concerned about the viability of Equitable in the longer term, and they set out their particular concerns. They concluded that the position would worsen if Equitable lost the court case.
65.Equitable submitted their 1998 regulatory returns on 30 March as requested. The same day they applied for a section 68 order to allow a future profits implicit item of £1bn to be used towards their required solvency margin on 31 December 1999 (they had included a future profits implicit item of £850m in their 1998 returns). On 9 April GAD reported to FSA the results of their initial scrutiny of Equitable's 1998 returns, saying that the financial position appeared satisfactory, but they had not yet seen a copy of the finalised reinsurance agreement and they asked the prudential division to request it urgently, which the prudential division did.
66.On 20 April Equitable told the prudential division that the reinsurance agreement had not yet been completed, and they sent a copy of the terms sheet which would form its basis. That showed that the reinsurance agreement remained contingent on no change being made to Equitable's then current GAR bonus practice, either by choice or as a result of legal action; and that if the withheld claims balance exceeded £100m, negotiations would take place to find a mutually acceptable restructuring of the agreement. Equitable also enclosed a copy of a paper prepared for their Board on measures to protect their statutory solvency position. One issue that the paper discussed, but could offer no solution to, was how Equitable might use policy conditions to restrict the growth in GAR business.The paper concluded with a list of measures which it was said would seem sensible to pursue. Commenting subsequently on those measures, GAD said that they seemed "fairly plausible" but could ultimately reduce investment returns. They were also content with the level to which any future repayment premiums under the reinsurance agreement had been subordinated to policyholders' rights.
67.On 4 May Equitable provided the projected solvency information which FSA had requested on 1 February (see paragraph 62). This showed three different scenarios, each making different assumptions as to developments in the investment markets. All three showed Equitable remaining solvent and the position improving steadily. They had attempted to project the impact of losing the court case, although they said that was difficult to do as there were a number of varying components. In their view, however, the key solvency consideration of an unfavourable outcome was replacement or modification of the reinsurance arrangement, which was being actively pursued.
68.On 20 May GAD provided FSA's prudential division with a scrutiny report on Equitable's 1997 and 1998 regulatory returns; this gave Equitable a priority rating of 2 (up from 3 for the 1996 returns - see paragraph 49). They highlighted a number of problem areas but concluded that, because of the way they operated, Equitable should be able to work their way out of their solvency margin problems. They needed however to hold back more emerging surplus by declaring lower guaranteed bonuses; and to give policyholders greater warning about the possible implications for bonuses of a substantial market setback. The following day GAD suggested to FSA that Equitable should be asked to consider further possible scenarios and to confirm the basis of some of their calculations. Meanwhile, Equitable had written to the then Economic Secretary complaining about the level to which they were being required to reserve for GARs; she replied on 14 June.
69.In the meantime both the prudential division and Equitable had been considering the possible outcome scenarios to Equitable's court case and the resulting implications. On 21 June Equitable told the prudential division that their lawyers had identified six possible scenarios, but that they considered all of them except for two, namely complete success, or success but with some adverse comment to be highly unlikely. Nevertheless, Equitable had been discussing with the reinsurer possible amendments to the reinsurance agreement, and discussing other possible arrangements with other reinsurers. The next day the prudential division reviewed Equitable's court papers and commented that they made no mention of policyholders' reasonable expectations. On 24 June FSA's prudential division asked their conduct of business division if they had any jurisdiction over the bonus notices issued to policyholders, and whether they could require Equitable to change them. They sent the conduct of business division copies of the 1996 and 1997 notices, which they said they thought were possibly misleading, and said that they would forward the 1998 notice the following week.
70.On 25 June, prompted by concerns expressed by GAD on the likely consequences if the court referred the issue of policyholders' reasonable expectations to FSA, the prudential division prepared a paper on action FSA might need to take if the court did not give a clear view on how policyholders' reasonable expectations might be viewed. They said that they saw no point in reaching a view ahead of the court judgment, but that they would do some more work on it so as to be ready to give a view shortly afterwards. They added that Equitable's bonus notices, which seemed to give policyholders unrealistically high expectations of the pay-outs they could expect, were currently the main evidence in support of the argument that Equitable's approach was not consistent with policyholders' reasonable expectations. They had raised that matter with Equitable previously, but they had not as yet made any progress in obtaining changes.
71. On 29 June Equitable met GAD and FSA's prudential division to discuss further information they had provided, and the court case. Equitable said that their lawyers considered it very likely they would win the court action but with some adverse comment, but considered the worst case scenario (whereby bonus rates for both the cash fund option and annuities had to be equalised at the highest cash level) as inconceivable. The prudential division pointed out that, even if Equitable won, FSA would still need to consider whether their bonus policy met policyholders' reasonable expectations; they said that they had concerns about information contained in bonus notices, but had not yet reached a view on that. Equitable insisted that their practice of paying out as much as possible in bonuses and not building up any hidden estate offered best value to policyholders, as well as being a useful deterrent against predators. Equitable said that they had been approached by a number of suitors, but the reply had been that they were committed to mutuality.
72.The court hearing began on 5 July and the same day the prudential division sent FSA's managing director and the conduct of business division a note about the legal action and the implications both for Equitable and FSA in terms of follow-up action required. They set out the implications of three possible outcomes: Equitable winning, winning in part, and losing the case. In the last case the reinsurance would then be invalid, although Equitable had established that there was scope for replacing it; should that not be possible Equitable would only just cover the required minimum solvency margin after taking full account of future profit implicit items. Equitable would need to consider drastic measures which might precipitate a take-over bid or a reduction in business. The prudential division would need to determine the company's solvency position and, if the required minimum margin was breached, to require a plan for the restoration of a sound financial position. Even if the solvency margin were not breached, the prudential division would require steps to be taken to strengthen the position in the short to medium term. There would also be the question, if there were a significant risk that Equitable would be unable to meet their liabilities to policyholders, of whether to close the company to new business or suspend their authorisation.
73.On 9 September the High Court ruled that Equitable were entitled to operate their differential terminal bonus policy, but the opponent was given leave to appeal. GAD told FSA that they could see nothing in the judgment which was inconsistent with the guidance they had issued on the subject, although FSA might need to consider intervening in respect of those policyholders whose expectations might not have been met. FSA's legal division also pointed out various issues arising for FSA relating to policyholders' reasonable expectations, but noted that the prudential division had decided to defer a decision on taking action until the appeal had been concluded. On 15 September the prudential director suggested to the conduct of business director that they needed to consider the matter from the perspective of all the FSA constituent bodies but should not decide on any action until the appeal court's decision was known. If the judgment were overturned it was possible that action would be warranted under the 1982 Act, and he wanted to avoid any action which might constrain or prejudice such action. They would consider the matter further in the light of an analysis that they had agreed should be undertaken while the appeal was pending.
74.On 23 September the conduct of business division responsible for regulating PIA member firms wrote to their prudential colleagues about the Equitable bonus notices which they had referred to them (see paragraph 69). The conduct of business division said they did not consider Equitable's bonus notice to be poorly presented or inaccurate and did not therefore intend to take action under the 1986 Act and the PIA Rules. They went on to say that historically they had not regarded post-sales literature as within their remit and would therefore have to have serious concerns about a document before taking action against a company.
75.The next day GAD advised that Equitable's application of 30 March 1999 for a future profits implicit item of £1bn could be accepted by FSA. They confirmed that the calculations provided were in line with the guidance and that the sum applied for was only about one third of the sum for which they could have applied, and was substantially less than they had been allowed in 1998. However, Equitable should first be asked for certain confirmations and for a copy of the reinsurance agreement as finally signed (which Equitable subsequently provided and GAD accordingly confirmed as acceptable). The prudential division accordingly recommended to the Insurance Supervisory Committee (see paragraph 18) that the application be granted. They told the Committee that, while there was some debate at the margins between Equitable and GAD about the reserve for GAR options, the prudential division were generally satisfied that Equitable were adequately reserved for their exposure to GAR options, which had "been largely offset" through reinsurance. The Committee approved the application and the Treasury issued the order on 9November.
76.On 17 November the prudential division prepared a risk assessment of Equitable as part of piloting a new approach to company assessment. This suggested that Equitable should be seen as a high financial risk for a number of reasons which they detailed. The assessment said that, while Equitable had not been alone in being caught out by the GAR issue, they had not woken up to it quickly enough, and communication to policyholders of their change in policy in relation to bonuses was decidedly unclear and left Equitable open to criticism. The overall assessment prepared as part of the regulators' co-ordinated supervisory programme (see paragraph 36) confirmed Equitable as medium to high risk.
77.On 21 January 2000 the Court of Appeal gave judgment against Equitable by a majority of two to one. One of the majority judges, however, went on to say at the end of his judgment (in a comment that did not form part of his reasoned decision) that it was legitimate in his view for Equitable effectively to ring-fence funds relating to different types of policyholder, which could result in those policyholders with GARs not doing much better in cash terms. Equitable were granted leave to appeal to the House of Lords and were permitted by the court in the interim to continue their differential terminal bonus policy pending the appeal on Equitable's assurance that if the Court of Appeal's decision was upheld, Equitable would pay additional sums in respect of any policy maturing after the Court of Appeal's judgment. GAD told the prudential division that the judgment meant that most of the advice in the guidance note issued by the Treasury on 18 December 1998 remained valid. They suggested that the extra costs to Equitable might be fairly marginal, but that Equitable should be asked to confirm that the judgment did not affect the reinsurance agreement. The prudential division told their conduct of business colleagues that the judgment gave no cause for panic. Although the publicity was likely to dent Equitable's sales, their reserving requirement would not be affected and so their regulatory financial position would be largely unaltered.
78.On 28 January the prudential division prepared a note setting out the implications for the insurance industry if the House of Lords were to uphold the Appeal Court's judgment. They said that, although Equitable would need to revise their bonus policy for future years, the new approach need not lead to any significant additional costs for them. The legal division circulated a summary of the judgment, commenting that each of the four judges who had at that stage considered the case [the High Court judge and the three Appeal Court judges] had arrived at their respective conclusions for different reasons. It was therefore not possible to predict the House of Lords' decision, and any attempt to do so, or to determine the implications of the Court of Appeal's judgment, would be of little benefit. Over the subsequent months discussions continued internally about the wider implications of the Equitable court judgment for policyholders' reasonable expectations more generally.
79.Meanwhile, on 1 February, Equitable had written to policyholders assuring them that there should be no significant costs for Equitable were the House of Lords to uphold the Court of Appeal's judgment. On 22 March Equitable published their Directors' report and accounts for 1999 and declared a bonus of 5%. The accounts stated that a prudent provision of £200m had been included for GAR options. The Directors' report made no specific mention of the legal action, but the parallel Annual Report did set out the background to the litigation and progress up to then (they said they expected the House of Lords' hearing to be in June and the judgment to follow shortly thereafter). At the end of June Equitable submitted their regulatory returns for 1999 and applied for a section 68 order for a future profits implicit item of £1.1bn for use in their 2000 accounts. On 7 July GAD recommended that the application be granted on the grounds that there was a significant margin between the sum applied for and the maximum for which Equitable could have applied (£3.3bn), and the appointed actuary had confirmed that he had taken account of the reinsurance agreement in determining the value of the future profits.
80.On 4 July FSA's relevant managing director told senior colleagues that one of Equitable's directors had approached him to say that there were "straws in the wind" that the Lords would find against Equitable. Equitable were considering "what level of sacrifice" might be needed at the top of the organisation. On 18July Equitable met with FSA's prudential and legal divisions and GAD to discuss contingency planning for the House of Lords' judgment which was due on 20July. They thought it unlikely that the House of Lords would find against Equitable, but discussed the possibility that Equitable might be prevented from altering the rate of bonus for policies containing GAR options. Whilst this had previously been identified as a possible [but not a probable] outcome, it was beginning to appear more likely in the light of the arguments put forward for the first time at the House of Lords' hearing. The cost of that outcome (referred to as the third option) would be in the region of £1bn to £1.5bn and would have a profound effect on Equitable's regulatory solvency. Equitable had not attempted to renegotiate the reinsurance agreement to take account of such a ruling and such renegotiation was unlikely to be viable. In the event of such a ruling, they would immediately announce their intention to seek a partner. Although Equitable did not believe that they would then be insolvent [in other words that they would breach their regulatory solvency requirements], they were keen to avoid precipitous regulatory action should the judgment go against them, mainly because that was likely to have a detrimental effect on the value of the business. The prudential division said that they would not rush to take remedial action in such circumstances, but would need to be convinced that a suitable buyer was likely to be found quickly. Equitable said that, if the House of Lords simply upheld the Court of Appeal judgment, they expected to reduce the bonuses payable to GAR policyholders as a class; they did not consider that that would contravene the judgment.
81.The following day (19 July) the prudential division prepared a note (effectively an update of earlier scenario planning) setting out the possible outcomes of the appeal, and the regulatory action that was likely to be appropriate in each case. The note recognised the third option (see paragraph 80) as a possibility, but much less likely than the other two potential outcomes. Should the third option become reality, Equitable would only just be able to meet their required minimum margin and would therefore seek a partner.It was expected that there would be no shortage of potential partners.
82.On 20 July the House of Lords' judgment held, both in terms of the GAR policies and Equitable's Articles of Association, that Equitable could not apply different rates of bonus depending on whether or not the policyholder took benefits based on GARs, and that they could not pay lower bonuses to GAR policyholders as a class (ring-fencing). Equitable immediately announced that they were seeking a buyer, and told the prudential division that they planned an immediate cut of 5% in the value of all with-profits policies on non-contractual termination and that no bonus would be allotted for the first seven months of 2000; they said that they expected bonus levels to be restored once a sale had been completed.
83.The next day the Treasury told FSA's prudential division that it was likely that they (Treasury) would be asked for a brief on the situation with Equitable. They said that the judgment prompted thoughts on the wider implications for the future development of the life insurance sector and the effectiveness of the regulator. They set out a number of key questions, including whether FSA ought to have done more and said that, while they did not want answers at that stage, FSA should consider those points and be ready to respond at short notice.
84.On 24 July the prudential division told GAD that, in their view, the House of Lords' judgment had no implications for the life insurance industry as a whole, because they had required companies to reserve fully for GAR options with the same level of reserve being required whether or not differential terminal bonuses were paid. The impact had been different for Equitable because the judgment had led to a reduction in assets, as it had rendered void the reinsurance agreement, rather than an increase in liabilities. GAD replied, confirming the prudential division's analysis. They said that, in retrospect, Equitable had acted imprudently in taking credit for the reinsurance. In an internal minute, the prudential division commented that while a sale could not be regarded as an absolute certainty, it had to be close to 99.9%. They also circulated an action plan under which FSA were to obtain confirmation as to Equitable's regulatory solvency and review projections of future solvency; review the 1998 guidance; ask other companies what implications they saw for themselves; and arrange discussions with Equitable about the bidding process.
85.On 26 July Equitable announced the changes to their bonus rates (see paragraph 82), but added that through the sale they would be looking to secure funds to make good the lost growth. The same day Equitable's appointed actuary wrote to the prudential division setting out the company's solvency position. He said that, while he accepted that the company's position would be unacceptably weak on a continuing basis, in view of the steps that they had taken to strengthen the position, Equitable should be regarded as meeting the required minimum margin.
86.The same day the prudential division replied to the Treasury's questions (see paragraph 83). On the matter of whether the guidance the regulator had issued on meeting the cost of GARs had been right, they said that it would have been difficult for any guidance to be consistent with the full range of judgments that had appeared. If they had been wrong, then so too had the actuarial profession, since the Faculty and Institute of Actuaries had gone on record as saying that they fully supported the guidance. The prudential division said that they were not convinced that either the Treasury or FSA could or should have pushed Equitable to alter their bonus practice; that practice "was not clearly unlawful", as had been demonstrated by the first judgment and the fact that the Court of Appeal had found against them only by a majority.
87.On 11 August Equitable, the prudential division and GAD met to discuss the regulatory aspects of the sale process. On 24 August the prudential and conduct of business divisions met to discuss the House of Lords' judgment and its implications. The prudential division said that it was hoped that a buyer would be identified by December, and that the process could be completed by June 2001. The judgment was not considered to have regulatory solvency implications, but Equitable had experienced a weakening of their financial position because the reinsurance had been conditional upon their continuing to pay differential terminal bonuses, and so had been terminated following the judgment. The reinsurance agreement had been renegotiated, which had given the company "a bit more breathing space"; however, the solvency position "remained tight". As a result of that meeting, the conduct of business division concluded (see paragraph 120) that Equitable remained solvent and need not therefore be required to make specific disclosures to new policyholders.
88.On 1 September the appointed actuary submitted Equitable's solvency update to 31 July which showed excess assets of £1.3bn. The same day the prudential division recommended to the Insurance Supervisory Committee that they should grant Equitable's application for a future profits implicit item of £1.1bn. They said that, although Equitable had been weakened as a result of the House of Lords' judgment, they were still solvent. They were seeking only a third of the sum to which they were entitled, and the relevant calculation had been checked by GAD. As a result, on 11 September the chairman of the Insurance Supervisory Committee told members, by e-mail, that Equitable's section 68 application involved a "fairly standard request" for a concession for a future profits implicit item. The prudential division's recommendation made clear that Equitable's request was well within normal parameters, and he saw no difficulty in agreeing to the recommendation. He added, however, that the implicit item was an important aspect of Equitable's overall financial position and, given the company's high profile at the time, some members might wish to discuss the paper. One member responded with two detailed points on the practicalities of taking credit for the future profits implicit item. The Committee approved the application the same day without meeting and on 13 September the Treasury issued the section 68 order.
89.At their quarterly meeting with FSA the following week the Treasury pointed out that Equitable were still advertising for new business. FSA repeated that Equitable's difficulties did not affect their solvency, only their freedom to invest.
90.On 21 September the relevant managing director told the FSA Board that the House of Lords' judgment had gone much further than the previous court ruling in that it had said that Equitable could not "ring-fence" GAR business from other with-profits business for the purpose of setting the terminal bonus. The extra costs of the GARs therefore had to be spread amongst all policyholders in the fund. This had potentially serious implications for the reasonable expectations of other with-profits policyholders. The next day GAD told the prudential division that they had no questions to raise about Equitable's regulatory solvency at that time, although they pointed out that without the future profits implicit item, Equitable would have excess assets of just £300m.
91.On 9 October the appointed actuary told the prudential division that as at 31August Equitable had excess assets of £2.165bn. He said the huge change from the July position was due to the markets having strengthened in the interim. Meanwhile, since Equitable had announced in July that they were seeking a buyer (see paragraph 82) a large number of bidders had expressed an interest and had been assessing Equitable's financial position. A number of those had since withdrawn. In a report to the FSA Board on 19 October the managing director said that, despite difficulties in assessing the level of liability arising from the House of Lords' judgment, Equitable had received three serious offers to buy them, all of which were high enough to enable repayment of the bonuses withheld for the first seven months of the year, with an additional payment for goodwill. However, FSA would need to see the detailed bids and structure to determine whether the with-profits funds were strong enough to secure the desired restoration of investment freedom going forward. On 30 October Equitable's appointed actuary provided solvency figures which showed excess assets as £1.14 bn at the end of September.
92.On 31 October a potential bidder for Equitable, (whom I call bidder A) told FSA that they believed that the shortfall in Equitable's funds was greater than Equitable themselves had estimated. Bidder A expressed concern that the wording of Equitable's policies allowed GAR policyholders to increase their contributions to the fund, to which the guarantee would attach, thereby increasing the fund's liabilities to the detriment of other policyholders. They said that they were investigating whether and how that liability might be capped, but said that they were more pessimistic on the issue than were Equitable's directors. The same day at a meeting of FSA's Firms and Markets Committee, FSA's Chairman expressed concern over press reports that there was little interest in purchasing Equitable; he saw a risk of them reaching the position where only one bidder remained. For the moment, however, there were still three bidders and it was still thought likely a sale would be achieved.
93.Meanwhile GAD had been considering possible ways by which Equitable might cap the liability arising from GAR policyholders making topping up payments, short of stopping Equitable from writing new business which, they said, would almost certainly end any chance of a sale. [Although GAR policyholders in fact had a contractual right to make top-up payments even after any closure to new business.] They noted however, following a meeting with Equitable and the prudential division on 3 November to assess Equitable's position, that Equitable did not appear to believe that the issue was a serious concern for potential bidders. GAD also recorded that the aggregate value of the recent cut in bonus rates amounted to £1.5bn, which was expected to be sufficient to cover the cost of paying GARs on full asset shares. That meant that new policyholders should not have to meet the cost of GARs, although they would be joining a very weak fund. GAD noted that if no sale were to take place Equitable would almost certainly have to stop writing new business, and very probably have to rearrange their investments to a more defensive position to protect against possible liquidation in the event of a substantial fall in equity values. In the light of further complaints from policyholders about the appropriateness of Equitable's advertising, the prudential division prepared a draft response to them, which they circulated to conduct of business colleagues. They said that, as Equitable remained solvent and continued to meet the statutory regulatory requirements, there was no reason to stop them from marketing their products, nor did their advertisement appear misleading.
94.On 6 November another potential bidder, bidder B, met with the prudential division and GAD and expressed significant concerns about the risks they would be taking on if they were to acquire Equitable; the reinsurance agreement; a Zillmer adjustment (see paragraph 30) included in Equitable's resilience reserve; and the possibility that, given Equitable's precarious regulatory solvency position, Equitable might "go through a period of statutory insolvency" before making a recovery. On 9November bidder B told FSA's Chairman that, although they had been very interested in acquiring Equitable, they had reached the view that the financial position was considerably worse than they had first thought, and perhaps rather more doubtful than FSA had been led to believe. They expected soon to tell Equitable that they did not wish to proceed.
95.In an internal note dated 15 November the prudential division set out how each of the possible outcomes of the bidding might be handled. While noting the serious concerns raised by potential bidders about Equitable's exposure to certain liabilities, the prudential division concluded that there were still no grounds for considering action on the basis of regulatory insolvency, as Equitable were able to meet their contractual obligations. The same day bidder B told the prudential division that they considered it would not be worth taking Equitable "at any price". Some current policyholders were clearly expecting a restoration of bonuses foregone and perhaps even a demutualisation bonus, expectations which would be impossible to meet. The following day GAD commented that if no buyer were found, and Equitable intended to remain open to new business, FSA would have to require Equitable to commission an independent investigation into their viability. They said that Equitable were very close to not covering their required minimum margin for regulatory solvency. It would be difficult to arrange a rescue by another insurer should they become technically insolvent.
96.Over the next two weeks FSA's prudential division continued to explore with the potential bidders various issues including: the possibility of capping Equitable's liabilities; whether the acceptance of payments into non-GAR policies (which might then have to be used to subsidise GAR policy payments) might be viewed as mis-selling (the conduct of business division said not if an appropriate warning had been given); whether the proposals would meet policyholders' reasonable expectations; and whether a future profits implicit item could be transferred to the buyer. Equitable and GAD also continued to debate the determination of appropriate reserving levels. The appointed actuary reported Equitable's excess assets at the end of October as £1.08bn.
97.On 24 November GAD submitted their detailed scrutiny report on Equitable's 1999 regulatory returns. Although the solvency position appeared reasonable, with available assets of £3.861bn to cover a required minimum margin of £1.114bn, they noted that that figure included a future profits implicit item of £925m, disregarded liability to repay a subordinated loan (paragraph 31) of £346m, and benefited from a reduction in liability of almost £1.1bn resulting from the reinsurance agreement. Without those factors, the available assets would reduce to £1.511bn. The report went on to cite a list of further weaknesses in Equitable's position, and added that the question of whether Equitable should continue to sell non-GAR policies in a common fund with GAR policies could be considered an "environment risk".
98.On 29 November the prudential division told FSA's managing director and Chairman that two potential bidders [bidders A and C] remained. Equitable's preferred bidder [A] were to submit a recommendation to their Board on 7December on whether to bid or not. At a meeting between Equitable, the prudential division and GAD on 1 December however, it was concluded that there now seemed to be only one realistic bidder remaining [bidder A] and it was doubtful that the sum they would offer would be sufficient to allow Equitable to proceed with the sale. Should that be the case, it was likely that the company would close to new business and sell the sales force and infrastructure. It was noted that there was still disagreement between GAD and Equitable on the reserving requirement and on the use of the Zillmer reduction. It was also noted that Equitable had not considered whether policyholders who had joined after the House of Lords gave judgment could be excessively disadvantaged in a closed fund, since from that date it had been known that preferential treatment would be given to GAR policyholders. Equitable's managing director confirmed that the sales force had been adequately briefed and instructed to advise potential policyholders of the company's circumstances. He said that Equitable had taken legal advice as to whether they should continue to write new business. That same day the prudential division met with the two remaining potential bidders [A and C] and it became apparent that they might both be about to pull out of the process.
99.Bidder C pulled out on 4 December after Equitable felt unable to agree to allow them a period of exclusive negotiation, and the same day bidder A told FSA that they were becoming increasingly concerned that acquisition of Equitable would be uneconomical. They said that they could not predict their Board's decision on 7 December. On 5 December FSA's prudential division told their managing director that GAD had made possible adjustments to the free asset estimates provided by Equitable to include various assumptions in the reserving basis which would bring them into line with what GAD would normally expect. If all the assumptions were correct and all the adjustments made, this would leave Equitable with free assets of only £70m [this was an arithmetical error; the correct sum was £20m - see Appendix C, entry for 1December 2000] above the required minimum margin, some £1,010m less than Equitable's own estimate. If no bid were forthcoming, they believed that FSA would have grounds for closing Equitable to new business, either for failing to meet the required minimum margin or because of the risk that policyholders' reasonable expectations would not be met. However, they would prefer Equitable's directors to take that decision.
100.On 5 and 6 December urgent meetings were held (including internal FSA meetings, the FSA Chairman's Committee and with Equitable) to discuss the implications if the final bidder withdrew. An urgent meeting of the Tripartite Standing Committee (see paragraph 37) was called on 6December to discuss whether the closure of Equitable would have any systemic consequences for financial stability. The Committee noted that closure to new business would be the only option if the sale fell through. They agreed that Equitable's position had been unique, which meant that the House of Lords' judgment had had a particularly significant effect on them. It was noted that Equitable could not refuse top-up payments from with-profits holders with guarantees, even though they would potentially harm non-GAR with-profits policyholders. FSA said that that was why, given Equitable's lack of substantial surpluses, they could no longer prudently write new business. Treasury officials also briefed the Economic Secretary that a sale was unlikely to take place; they said that this was mainly because it was impossible to cap Equitable's GAR liabilities. They said that, while it might be argued that the regulator should have stopped Equitable writing new business sooner, there had until a few days previously been every sign that a sale could be achieved. The regulators had been just as surprised as the markets that no buyer could be found. The briefing said "Does this event show up a deep-seated oversight on the part of the regulator?Probably" (in failing to ensure that proper risk management processes were in place at Equitable), but that oversight had not been life threatening until the Lords' judgment, the scope of which had been quite unexpected so far as the prudential division were concerned. On 7December bidder A withdrew and the following day Equitable closed to new business. At a meeting of the FSA Firms and Markets Committee the next day the minutes show that it was queried whether proper disclosure about the firm's position had been made since the House of Lords' judgment. A committee member suggested that, if it had not, "policyholders might be able to claim compensation for mis-selling. There might also be a need to consider disciplinary action."
101.The next quarterly meeting between the Treasury and FSA took place on 13December. According to a Treasury note of the meeting (which Treasury say was written some weeks after the discussion on the basis of a contemporary manuscript note), ring-fencing the GAR liability by buying out the options would have cost bidder A over £1bn and the company could not afford to do that in addition to the launch of stakeholder funding. The prudential division were reported as then saying that neither FSA nor Equitable had realised the extent of the GAR liability. Equitable had thought that the liability was capped and FSA had not appreciated the scale of the problem; FSA had said that the whole GAR experience had been a "wake-up call" for them and for the industry to review their structure and their strategies. The prudential division had reported that the House of Lords' judgment had been completely unexpected. Regarding allegations that had been made of mis-selling after the House of Lords' judgment, the prudential division said that, although a script provided to Equitable's sales force by the company had not dealt with the problems, it would have been unreasonable to stop the company from continuing as a going concern while a sale was anticipated.
The Treasury's comments on the complaint
102.The then (December 2001 - see paragraph 2) Permanent Secretary to the Treasury said that in his view the actions of FSA as described in the Baird Report (see paragraph 40 and Appendix B) did not constitute maladministration. He said that he had no reason to disagree with the accuracy of the factual sections of the Baird Report and he had nothing new to add to them. However, it had to be remembered that the Report had been prepared with the full benefit of hindsight and dealt with only two years out of a story that covered more than 40 years in total. The essence of Mr P's complaint was that because FSA had failed to take regulatory action, Equitable had been able to continue to encourage investors to take out policies, without the investors being fully aware of the risks involved in investing in Equitable. Mr P had contended that, had he been aware of the true position, he would not have purchased a with-profits annuity. However, the Treasury said, providing an explanation of the risks involved in investing was first and foremost a matter for Equitable; it was for the conduct of business regulators to identify whether or not Equitable had complied with the specific risk disclosure rules and other conduct of business obligations to which it was subject. Although both prudential and conduct of business regulation were carried out by FSA during the period under review, they did so under entirely separate arrangements. FSA staff had carried out conduct of business regulation on behalf of PIA under contract.
103.The Permanent Secretary went on to say that FSA had accepted, with hindsight, that things could have been better handled. However, regulatory decisions had to be taken, frequently under time pressure and on the basis of the available, often incomplete, information and balancing conflicting interests. The processes by which decisions were reached were appropriate and the judgments made by the prudential supervisors in FSA were within the bounds of reasonable discretion. While, therefore, the Treasury accepted with hindsight that things could have been done better, they did not accept that the actions of FSA constituted maladministration.
Paragraph 104
