Case No. C.1597/01para 104 - 167
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Part II: C.1597/01
Introduction | |
Background to the complaint | |
Chapters 104 - 167 | Further evidence & developments |
Chronology & conclusion |
Further evidence gathered from interviews and correspondence
The interview evidence cited below includes only key commentary or additional evidence given to my officers. As the interviews covered much the same ground and events, albeit from different perspectives, a good deal of the evidence given at interview served only to repeat or emphasise the same or similar points. Those points have not therefore, in general, been repeated in each section.
The Treasury
104. My staff interviewed Treasury officers A and B who had been the Head of Department (responsible for various aspects of the Treasury's interests in the regulation of retail financial services) and Director of the Financial Sector respectively within the Treasury at the relevant time. Officer A said that while Treasury Ministers would be answerable to Parliament for any policy issues arising, lead responsibility for dealing with regulated firms rested with FSA, not the Treasury. Consideration of section 68 orders had not been purely mechanistic, but had involved intellectual input from the Treasury. She had not however been involved in Equitable's applications during that period. She had had frequent, almost daily contact with FSA, including commonly having contact with them in respect of insurance regulation several times a week. The quarterly meetings discussed matters of concern, or those issues which might pose a threat to the insurance industry. Once Equitable had begun their legal action, the Treasury had explored with FSA whether Equitable's differential terminal bonus policy was acceptable in terms of meeting policyholders' reasonable expectations. Officer A had been surprised at Equitable's and FSA's defence of the policy. The Treasury's interest was to see that FSA were taking an appropriate course of action, rather than to second guess their judgments. Having discussed it, the Treasury could appreciate that the matter was arguable. They were satisfied that FSA had considered the matter and not simply taken Equitable's view. After the Court of Appeal judgment, and again after the House of Lords' judgment, the Treasury had asked FSA how confident they were that Equitable should be allowed to continue taking new business. Both times, the Treasury were satisfied that FSA had identified, researched and considered the issues before reaching a view.
105. Following the House of Lords' judgment, officer A had been surprised to see that Equitable continued to advertise actively on television. She had asked FSA whether it was acceptable for them to continue to do so and FSA had replied that responsibility for the management of Equitable was primarily a matter for Equitable's Board. However, FSA thought it reasonable for Equitable to expect to sell their business as a going concern and to maintain its market presence in order to underpin its prospects for a successful trade sale.
106. Officer A said that the outcome of the appeal had not been the one that FSA had expected. They had identified it in their scenario planning as a possibility, but had considered it unlikely. As for the "deep-seated oversight" comment in the briefing submitted to the Economic Secretary on 6 December 2000 (see paragraph 100), officer A (who had not been present at the 6 December meeting) said that in making that comment the officer providing the briefing had probably surmised that historically the prudential regulators had not been requiring insurance companies to balance their liabilities against their ability to meet them at current market conditions in the same way as was normal practice in other areas of the financial market. It was important to view this difference in the context that problems with insurance companies tended to develop slowly. The sudden collapse [i.e. closure to new business] of a major life company was unprecedented and they had been in uncharted territory.
107. Officer A added that the minutes of the quarterly meeting on 13 December 2000 (see paragraph 101) were accurate in terms of the subjects raised, but did not capture the full flavour of the exchange. The discussion had looked at what would happen to Equitable; what would happen to the insurance sector as a whole; what action, if any would be required of Ministers; and prepared for any questions that might need to be addressed. FSA had been asked whether they planned an inquiry, since had supervision still been with a government department, that department would have been asked to account for its actions, and FSA might be expected to account in a similar way. The meeting had also discussed the events leading to closure. Officer A said that she knew two of the three main bidders fairly well and had had every reason to believe that they were serious.
108. Officer A said that FSA had satisfied themselves as to Equitable's solvency, although with the benefit of hindsight Equitable's assessment of their position had been superficial and it would have been desirable to go deeper; FSA had not appreciated the extent of Equitable's problems until it had become apparent during the bidding process. Officer A said that this assessment was not a criticism of FSA; it was a simple statement of fact.
109. As to the question of whether or not the judgment had come as a surprise, Officer A said that the Treasury view was that the judgment had been given and that to labour its unexpected nature might imply criticism of the judiciary. The judgment had not been what FSA had expected, but there had been nothing to gain in focusing on that. Officer A said that the message from FSA throughout 2000 had been that Equitable had not been easy to deal with. It had been because of Equitable's intransigence that they had been selected as an early candidate for the technique of risk-based supervision (see paragraph 36). FSA had faced significant problems in supervising Equitable, and in hindsight it was apparent that they were not getting the honest and full answers that they should have been given. She concluded that the Treasury had however been satisfied that FSA had been taking appropriate steps to explore the issues.
110. Officer B said that he was drawing entirely on his memory and recollection of the Baird Report except in relation to the discussion of the Tripartite Standing Committee meeting. Passing the supervisory function to FSA had been intended to achieve the benefits of a single regulator as far as possible within the then current legislation. All supervisory expertise had passed to FSA with none retained in the Treasury, whose minimum aim had been to see that supervision was carried out as it always had been. It had also been hoped that links would develop within FSA moving towards becoming a fully integrated regulator so far as was then possible. There had been no expectation of major change in the prudential supervision of the industry, however, as the old legislation was still in place.
111. Officer B said that FSA reported to the Treasury annually; quarterly meetings had been established to ensure that FSA kept the Treasury aware of any significant issues, and dialogue had continued with FSA on an almost daily basis, although there had been no records kept of such contacts; the Treasury kept
e-mails for only a limited period of time and did not record telephone calls. Through all these means and from close daily contact at all levels the Treasury had been satisfied that prudential supervision continued to be carried out as envisaged under the Contracting Out Order (paragraph 11).
112. Officer B said that, so far as the Equitable situation was concerned, FSA had kept the Treasury aware of each of the court hearings. The Treasury had not seen Equitable's position after the House of Lords' judgment as something on which they would act; the relevant expertise was in FSA and it was not for the Treasury to substitute their judgment for FSA's in supervisory matters or to query FSA's supervisory judgment, although it might be appropriate if there were concerns about implications for economic policy. The Treasury simply needed to be aware and needed in practice to be sure that the task of supervision was being carried out as it had been before; they knew that FSA were aware of the importance of the Equitable case and were giving it their attention.
113. The decision to seek a buyer after the House of Lords' judgment had been Equitable's, and FSA had considered that it was the right course to follow. It was not for the Treasury to take a different view, and officer B did not believe, even with hindsight, that the decision had been wrong. FSA had seen no reason why Equitable should not achieve a sale, and there had been the "plan B" option of closing them to new business if they did not.
114. As far as section 68 orders were concerned, officer B said the procedure was that FSA, having considered an application, would ask the Treasury to make an order. The Treasury would look at FSA's recommendation but relied on FSA's judgments as to what was or was not appropriate. The applications were being considered within FSA by the very same individuals who had been considering them for years previously in DTI and the Treasury. It would not be practical or appropriate for the Treasury to make a major scrutiny of such applications - there were up to 200 a year - and their scrutiny was therefore primarily limited to checks on process, which was a fairly routine task. The Treasury had sometimes asked for more information in connection with an application which they did check. It was not simply a matter of rubber-stamping. The applications from Equitable had been looked at carefully but nothing untoward had come to light. Officer B did not recall anything in particular about the application submitted after the House of Lords' judgment.
115. Turning to the 6 December 2000 briefing for the then Economic Secretary (see paragraph 100), officer B said that that had drawn largely on what FSA had said at the meeting earlier that day. The comment suggesting "a deep-seated oversight", however, had not been discussed at the meeting and was therefore "somewhat hasty".
Conduct of business regulators
116. To understand better the relationship between the two main regulatory bodies within FSA concerned with these events, my staff interviewed three officers who had been members of the conduct of business division in the relevant period. These were two former heads of the section responsible for supervising PIA Member firms (officers C and D) and the FSA conduct of business director to whom they reported (officer E).
117. Officer C had been in post up to March 1999. He said that prior to the prudential and conduct of business regulators being brought together, contact between them had been limited. If the conduct of business regulator had become aware of an issue relevant to prudential regulation they would draw it to the prudential regulator's attention, but such instances had been few and far between and there had therefore been very little contact between them. The two heads of the regulatory divisions had previously agreed that they needed to put more systematic liaison arrangements in place and from January 1999 onwards efforts had been made to do that. Asked if he perceived any conflict between their roles, officer C said that both the prudential and the conduct of business regulators were concerned with the protection of consumers: conduct of business regulation had focused on the individual investors, whereas the prudential regulators were concerned with the financial robustness of companies in being able to meet their liabilities to policyholders, which attached to individual consumers. It was a confluence rather than a conflict of interests. The prudential regulator was customarily seen as the lead regulator in respect of insurance companies, but in practice the concept had rarely been tested as there had rarely been any crossover between the two regulators: Equitable had been one of the first such cases.
118. Officer D had been in his conduct of business post from July 1999 onwards. He said that 'policyholders' reasonable expectations' was definitely a prudential concept, although there was a degree of overlap between the two regulators in that regard, of which Equitable was a good example. The conduct of business interest was whether Equitable were promising anything that they knew at the time of sale would not be delivered, whereas the prudential regulator would view this from a different angle, considering whether Equitable were able to meet reasonable expectations of policyholders during the lifetime of the policies.
119. Officer D said that the purpose of the lead supervision pilot (see paragraph 36) was to find out what useful and relevant information might be exchanged between regulators in order to help them make their risk assessments. Asked what level of information he would have expected from the prudential regulator with regard to a firm's financial strength, officer D said that in the first instance that was a matter for the prudential regulator; while his division had an interest, they did not need detailed information. Financial assessment was the prudential regulator's concern; a conduct of business interest would arise only if such an assessment concluded that a firm was not meeting its statutory solvency requirements. The question for the conduct of business regulators would then be how to handle that situation in accordance with the applicable PIA rules. The situation with Equitable had never reached that stage, however, as he understood that they had remained solvent and authorised to conduct insurance business; that was as much as the conduct of business division needed to know. He said that he knew that the solvency requirements were inherently conservative and that there were a number of "cushions" above "straight" solvency, that were required to satisfy the statutory solvency requirements. Asked whether the conduct of business regulator would have wanted to know of any trend that might suggest that a firm was heading for trouble, or whether they would not expect to be told until the statutory solvency margin had been breached, officer D said that it was generally speaking the latter.
120. With regard to Equitable's legal action, officer D said that the conduct of business division had been kept informed throughout the process; they had been told that Equitable remained statutorily solvent following the Court of Appeal judgment and that there was no cause for alarm and, following the House of Lords' judgment, that Equitable had decided to withhold seven months' bonus. They had not queried the prudential division's statement that there was "no cause for alarm" as to Equitable's financial position. They did not need to know the detailed position, although they had subsequently been sent an e-mail giving more detail. Officer D said that his understanding of the problem had been quite clear: Equitable had to cash in the reserves and had done so by suspending the reversionary bonus for the first seven months of the year. The major problem had been in respect of the reinsurance arrangements, and Equitable had solved that problem by renegotiating the terms of the reinsurance agreement. Asked whether there had been any requirement on Equitable to make any special disclosure to new policyholders after the House of Lords' ruling, officer D said that a judgment had to be made as to what was useful information; Equitable had been "several cushions" away from real problems. It was in the nature of insurance that there were cross-subsidies - those who claim are paid by those who do not. Equitable had made provision to meet their GAR liabilities. New policyholders were joining a pool over which others would have a claim, but that was true of all insurance funds. Officer D said that the conduct of business side would have wished to have been aware if the prudential regulator had been unhappy about Equitable's financial position, although the assumption was that they were content with a firm's solvency unless they said otherwise. He noted that Equitable's purpose in selling was not because they were insolvent, but rather to obtain a capital injection to replenish the seven months' bonus foregone and to attempt to repair their brand image. Officer D was asked whether the conduct of business regulator could require a firm that was still open to business to make specific disclosures to new customers relating to problems that it faced. Officer D said that his understanding was that where a firm had not breached the statutory solvency margin, there would be no grounds on which a special disclosure as to its overall financial position could be required to be made on top of the disclosures a company were required to make under PIA rules. Such a requirement might be seen as unreasonable and invite judicial review.
121. Officer E confirmed that he was satisfied that the prudential division had kept conduct of business colleagues informed. He had not felt any lack of knowledge about what was happening with regard to Equitable, nor had he been aware of any such feeling among his staff. They had actively engaged with the prudential regulator regarding the implications of the House of Lords' judgment, but as the matter had by then passed to FSA's relevant managing director, he personally had not been directly involved in the steps taken and had therefore had no real knowledge of what was happening at the time. He concluded that, where a company was solvent and meeting regulatory requirements, then there was a very steep barrier to a regulator taking special action, such as requiring risk warnings to be given.
Government Actuary's Department (GAD)
122. My staff also interviewed the officer (officer F) who had been head of GAD's insurance directorate at the relevant time. He said that a key factor in deciding on a company's priority rating was its solvency margin, and that consideration was given to any trends in changes as well as to the position in absolute terms. Priority two would indicate that a company was particularly weak and in need of early attention; perhaps 20 or 30 companies a year would be put in that category. On the basis of their 1996 returns, Equitable had been rated priority three, which indicated that GAD had identified no immediate cause for concern, although the company was marginally weaker than they would have liked. Equitable had been particularly sensitive to changes in market conditions, due to their lack of substantial free estate, and their rating would vary from year to year, normally between three and four.
123. Officer F said that the GAD survey had been commissioned following work carried out by the actuarial profession in connection with GARs; that work had highlighted areas of concern but, because companies taking part had been promised anonymity, GAD had been unable to identify the companies in question. They had therefore conducted their own survey to establish the extent of the problem and how companies were addressing it. The results showed that there was some improvement in the situation generally, in that almost all companies were making some provision for those liabilities; Equitable were a notable exception in making no provision whatsoever. It was also apparent that Equitable were more flexible than most in the terms on which guarantees were offered.
124. Asked about the progressively increasing level of Equitable's future profits implicit items, officer F said that that had simply reflected, and was, he believed, proportionate to, the increasing size of the fund and correspondingly increasing profits; it did not indicate any underlying weakness in Equitable's balance sheet. Having begun to use such items in their balance sheet in 1993 or 1994, it made sense for them to continue to do so. He explained that such concessions were particularly attractive for a mutual company in view of the limited options open to them in raising capital. Equitable's use of future profits items was in line with their culture of distributing profits fully among current policyholders when their policies became claims.
125. On the question of the section 68 application made in June 2000, officer F said that Equitable's entitlement was dependent upon the level of future profits that they could be expected to generate at a modest rate of return (in this case 5% a year), and that that would not be affected either by the House of Lords' judgment or by the level of explicit reserves on the balance sheet. Even a change in their investment portfolio (toward a higher proportion of fixed interest investments) was not considered likely to reduce future profits below the level required to support the size of the item applied for. Following the House of Lords' judgment, the reinsurance agreement had been renegotiated so that the threshold for when the agreement was triggered was reset at 60% take-up of GARs; while that meant that the benefit to Equitable was reduced, it did not affect likely future profits. Officer F was content that GAD's advice to the prudential regulator that the section 68 application met the relevant criteria remained valid after the House of Lords' judgment, and he believed that GAD had confirmed accordingly. Asked about the appointed actuary's continued use of the original resilience test (see paragraph 24) in relation to the regulatory returns, officer F said that the resilience test did not feature in the guidance on future profit implicit items. GAD could not require the appointed actuary to move to the amended test and an appropriate technical argument had been put forward as to why the old test was the appropriate one to use in the circumstances. GAD had considered what the position would be were the new test to be applied and had concluded that the difference was not significant.
126. Officer F said that the concept of policyholders' reasonable expectations was a nebulous one. However, the greatest conundrum in relation to Equitable was how to balance the expectations of policyholders as a whole against those of the GAR policyholders. His own view was that it was right to reflect the interests of all policyholders.
127. Asked about the then Treasury Insurance Division's document to FSA dated 5 November 1998, in which sudden concern had been expressed about Equitable's solvency, officer F explained that a significant change had occurred in 1998, in that interest rates had fallen from around 7% in 1997 to 4½-5%, increasing Equitable's GAR exposure and, consequently, the level of reserving required. He said that Equitable's previous years' returns had not revealed the extent of the company's GAR exposure or their reasons for believing that no specific provision was required; that had come to light only as a result of the survey and had been highlighted by the drop in interest rates.
128. In November 2000 Equitable had been close to not meeting their solvency margin, partly due to a drop in equity values. Officer F said that his understanding was that formal regulatory action (by way of closure to new business) was possible only if a company ceased to cover the margin. The regulator could have asked Equitable to produce a recovery plan if the margin of solvency had become uncovered but Equitable would then have been able simply to cite their proposed sale as such a plan. Asked what had changed GAD's view as to the wisdom of declaring a bonus for 1999, officer F said that in January 1999 Equitable had produced further figures from which GAD had been satisfied that they could pay the bonus and continue to cover the solvency margin - even without the reinsurance agreement - although the position would be thin. It was not, therefore, the reinsurance agreement alone that had enabled Equitable to declare a bonus, though it had been a contributory factor. On the question of reinsurance, he said that it was fairly common for such an agreement to remain unsigned for some time after coming into effect, and he did not believe that the reinsurer could have refused to honour the agreement prior to it being signed. He did not believe that earlier detailed scrutiny of the 1997 returns would have led to a different outcome.
129. With regard to Equitable's view, expressed at a meeting on 29 June 1999, that it was "inconceivable" that the case would go against them to the extent that it eventually did, officer F said that GAD had seen no reason to doubt the view that, while such an outcome was possible, it was indeed unlikely for a number of significant reasons. As for contingency planning, that was a matter for Equitable rather than the regulator; GAD knew that Equitable had identified the eventual outcome as a possibility and they had been asked to have a contingency plan in place. Had GAD been of the view that the House of Lords' judgment was a probability they would not have acted differently, except perhaps to advise the regulator to persuade Equitable more strongly of the wisdom of reducing the reversionary and terminal bonuses awarded in order to build up a reserve, and even then it would have been rather late for such advice to be of significant benefit. After the judgment, there had been no reason to assume higher than normal levels of withdrawals from Equitable as even in mid-2000 there had been no real uncertainty about the likelihood that a buyer would be found, and it had been widely believed that their business would then improve.
130. Officer F said that it was not correct to say that Equitable had been unable to meet the amended resilience test 2 (see paragraph 24) in late 2000, although in any event, Equitable could fail the amended test and still be solvent, as the new test was not required by regulation to be applied during the period under consideration. Referring to his e-mail to FSA's prudential division of 16 November 2000, in which he had said that Equitable were "unable" to meet one of the resilience tests, officer F confirmed that this was a reference to something that was broadly the revised test. He said that his use of the word "unable" was meant in the sense that, Equitable's appointed actuary was in fact "unwilling" to apply the test and was continuing to argue against it. It was apparent from information provided by Equitable that they could meet the requirements of the new test and he believed that the appointed actuary was arguing simply on a point of principle. Officer F said, that so far as he was aware, Equitable were able to meet the revised test 2 at all times from May 2000 until their closure to new business. Officer F concluded that the relationship with Equitable had been unusual. Even given the priority rating, the regulator would not normally have engaged in the level of dialogue with a company that it had engaged in in Equitable's case.
Prudential regulator
131. The officer who had supervision of Equitable within the prudential supervision team (officer G) said that Equitable's decision to go to court had been seen as a matter for Equitable and not something in which the regulator should interfere. It was, however, important for the regulator to know that Equitable were scenario planning; they had accordingly asked Equitable what planning they had done. The prudential regulator had also considered scenarios following possible outcomes.
132. Concerning Equitable's application in 2000 for a future profits implicit item for £1.1bn, officer G said that the application had first been passed to GAD to check the calculations and, after some discussion with the prudential regulator and Equitable, GAD had been satisfied that the reinsurance agreement did not compromise the level of the future profits implicit item for which Equitable was claiming. As GAD's approval of the application had pre-dated the House of Lords' judgment, he had asked them whether that judgment would have affected their view of the application; they had said that it would not. That conversation had not been documented, but the issue had not been thought to be relevant as the judgment would not have affected the calculation in any event. He explained that while the calculation would include an element of prospective income, that was based on business already in place, and assumed that the premiums due from that business would continue to be received.
133. Officer G said that it had been apparent to them that Equitable had been under strain. While the regulator would prefer to see all companies sufficiently strong as to have no need of concessions such as future profits implicit items, they had to recognise commercial pressures. There had been a general move across the industry toward larger future profits implicit items and Equitable's applications had been well within their entitlement. The trend did not trigger any power of intervention; to dictate further to the company would not have been reasonable and could have been regarded as putting the regulator in the position of shadow director. He concluded that no regulations had been breached.
134. Officer H had been the supervision manager from July/August 1998 until September 2000. On the subject of policyholders' reasonable expectations, she said that the prudential regulator had power to intervene where those expectations were not met. This was different to statutory solvency, in that there was a statutory requirement for a company to meet the detailed regulatory solvency requirements. It was very difficult to define policyholders' reasonable expectations and there was an element of "recognising it when you saw it". The regulator's approach had not been proactively to review policyholders' reasonable expectations, but to note if there was some indication that these might not be being met and then to challenge companies on whether they were meeting the expectations. The company would then have to justify their position or accept that they were not meeting those expectations. The Treasury had had no evidence of any large problems, other than in relation to two or three companies, so it was not proportionate to carry out a wide-scale review of the issue in those circumstances.
135. There had been no major issues in respect of Equitable reported to her until the early autumn of 1998, once the outcome of the GAD survey of the approach that companies were taking to GARs became known. A failure to reserve at a level the regulator considered appropriate would result in intervention, but it was unlikely to be proportionate to intervene and close a company to new business just because it had under-reserved for some particular liability where it otherwise remained solvent. It would be a matter that could be considered by the regulator, but closure would not necessarily follow. There would be a likelihood of legal challenge to such a move, and the regulator would need to be very sure of their ground.
136. As to whether the regulator might have provided guidance to the industry on the concept of policyholders' reasonable expectations, officer H said the prudential regulator had obtained copies of Equitable's case papers before the matter went to the High Court. Those had shown that the issue was being put before the court. Any definition that the regulator might have provided might therefore have been disagreed with by the courts, and so could have provided companies with a false sense of security. However, their review of Equitable's papers as part of the factual investigation had continued even so, because they wanted to be prepared to react swiftly, should the court direct the question of policyholders' reasonable expectations toward them. In their view the December 1998 guidance to all firms (see paragraph 52) and the Ministerial Statement in 1995 (see paragraph 33) went as far as the regulator could go in interpreting the law in this respect.
137. Asked whether closing Equitable to new business might have been in the interests of those who took out policies after the judgment, officer H said that the prudential regulator did have an interest in the risks to new policyholders and would stop consumers from joining a company that was not, and had no immediate prospect of becoming, financially sound. However, the main concern for new policyholders would be if they were misled as to the state of the company; that was a conduct of business matter. In the case of Equitable, the company was weak but selling the company appeared to be a reasonable plan for the restoration of Equitable to a comfortable financial position. Therefore the concerns were not sufficient to close Equitable to new business. In any event it was not clear, even after the House of Lords' ruling, that they had any grounds to do so, given that Equitable remained solvent. Any attempt would undoubtedly have met with considerable resistance and quite probably legal action.
138. Officer H said that, although FSA had undertaken detailed scenario planning before the House of Lords' hearing, their role had essentially been to prepare for the various possibilities, and not to predict which was likely to come to pass. They had concluded that, were Equitable to lose the case, the company would be left in a very tight financial position and would probably become a
take-over target. The reinsurance would fall away and they would barely be able to cover their liabilities and the required minimum margin. The prudential team had followed each stage of the legal action by means of transcripts of the hearings. It was only after the House of Lords' hearing began that it became apparent that the ring-fencing option referred to by the Court of Appeal might be ruled out. There had been nothing in the court papers prior to that to suggest the weight the arguments against ring-fencing would be accorded.
139. Officer H said that, in her view, while certain things might have been done better, or more quickly, she was convinced that there was nothing that the prudential regulator could have done during the time that she was involved that would have made any difference to the eventual outcome.
140. My officers also interviewed the head of prudential supervision (officer J). Describing the prudential regulator's approach, he said that competition had been the main driving force behind the government's economic policy at the time the regulatory provisions had been set up. The aim was to allow the best possible range of financial services at the best price, and to allow the industry as much freedom as possible in terms of competition and innovation; the price of that freedom was a requirement on the industry for disclosure (that is, detailed public disclosure of financial information). Regulations were regularly reviewed to determine which were really necessary, with the aim of removing any that were not. The phrase "light touch" had been used to describe the approach to be taken. Against that background, it was important that the regulator should be able to demonstrate that any action taken was reasonable and proportionate.
141. As for policyholders' reasonable expectations, the concept was particularly relevant to with-profits business, where a share of profits, rather than benefits guaranteed under the contract, was often the most important benefit. The distribution of that profit was a matter for the companies' discretion, and the requirement to meet policyholders' reasonable expectations was therefore effectively a control on arbitrary decisions by the company for a policyholder who would otherwise have no redress under the contractual terms of the policy. It was for the company to decide on what it thought was reasonable, and it was then for the regulator to intervene if it considered the company was not being reasonable. That enabled the regulator to look beyond the strict terms of the contract to see that companies acted fairly in exercising that discretion. With-profits investors could reasonably expect to follow the fortunes of the company; it was for the regulator to prevent abuse.
142. Officer J said that the letter from FSA to Equitable of 1 February 1999 (see paragraph 62) was a good example of how regulation had operated in practice. The prudential division had set out their view of the facts and had expressed concerns over the reinsurance agreement, which Equitable planned to look into with the reinsurer. Their letter had expressed strong views as to the wisdom of declaring a bonus if reinsurance were not in place and had reminded Equitable that they still had to think very carefully about the possible financial implications of the court case and the risk of the reinsurance agreement being cancelled. Whether to declare a bonus, and the level of it should they do so, were matters for Equitable's commercial discretion; in exercising that discretion Equitable would also have to consider the likely adverse implications for their business were they not to declare a bonus. The role of the prudential regulator was not to determine the amount of the bonus or whether a bonus should be declared, but to consider Equitable's decision and whether or not they should object to what was proposed. The onus to comply with the regulations was firmly on Equitable, but FSA were trying to give the Society the best steer they could as to the attitude the regulator would take on the exercise of their powers to intervene. He said that the threshold for intervention was very high; the regulator might intervene, invoking section 45 of the 1982 Act (see paragraph 34), if it was apparent that policyholders' reasonable expectations would not be met, although they would have always to consider the possibility of legal challenge to such intervention. They had been very much in new territory in addressing this issue. Officer J said that he was not aware that the regulator had ever prevented a company from declaring a bonus, and could not recall ever before having gone so far as they had done on this occasion in seeking to influence a company's bonus decision.
143. Regarding the letter which Equitable wrote to policyholders on 1 February 2000 (paragraph 79), officer J said that the prudential division had not seen it before it had been sent. While they might have suggested changes had they seen it before issue, the letter was worded in such a way that, though it clearly set out the best possible position for Equitable, it would have been difficult to say that it was actually wrong. Action by the prudential regulator to require withdrawal or correction might have been de-stabilising for Equitable, as policyholders might have read too much into such action, and it would have been disproportionate. While it could be argued that the tone of the letter had gone too far in reassuring policyholders, the words used were not so misleading as to give the prudential regulator grounds to intervene. The conduct of business regulator had also received a copy after issue. It had not been clear that it was a PIA issue, since it was not part of the sales process, although it was intended to inform policyholders.
144. Asked why Equitable had not featured on the agenda for the quarterly meetings between FSA and the Treasury in March and June 2000, officer J said that the meetings were to allow the prudential regulator to maintain contact with, and report back to, the Treasury in general terms; they were not decision-taking meetings. The agenda was proposed by the Treasury, although it was open to FSA to offer suggestions. He suspected that the reason Equitable did not warrant inclusion was that there had already been regular contact between them on the matter and so it was not seen as a helpful use of the meeting, the purpose of which was to raise matters that would otherwise have gone unreported. He said that communications with the Treasury were often by telephone and not necessarily recorded. Asked about the prudential division's reaction to the House of Lords' judgment, officer J said they had not seen it as the most likely outcome. The judgment had been disappointing. Although Equitable had maintained the view throughout that it was unlikely that the House of Lords would decide as they did, they had grown less confident as the hearing progressed.
145. As to the increasing use of the future profits implicit items in Equitable's returns, officer J said that most firms tried not to use them for fear that that might be regarded by the financial services rating agencies as a sign of financial weakness. Many firms applied for the concession but then held it in reserve, rather than use it in the regulatory return. Equitable's applications, and the sums sought, suggested that they were finding things increasingly tough, but they were entitled to the concessions under the existing regulations; officer J pointed out that the largest amount of future profits sought was much lower than that for which Equitable had been entitled to apply under the formula in the regulations.
146. Turning to the sales process, it was officer J's understanding that bidder B's conversation with the FSA Chairman on 10 November 2000 had been the first sign that they might be about to pull out of the bidding process. Whilst that had not been taken entirely at face value, because there had been a possibility that it was a negotiating tactic on price, FSA had certainly taken it seriously. It had been the first indication that any of the remaining major players were thinking of withdrawing. Another potential bidder had been exploring ways of capping the GAR liabilities; while there were tricky issues involved, there had been no reason to suppose that they were insoluble, and the possibility had to be recognised that the threatened withdrawal could simply have been a negotiating tactic. Officer J said that in earlier discussion Equitable had said that the top-up rate was low and they had reserved for it; there had been no reason at the time to suppose that the rate would change. Once the bidding process got under way, however, it became apparent that the rate might increase, since a sizeable injection of capital into the fund would make top-ups more attractive to knowledgeable policyholders; it had been that knowledge that had prompted bidder A's concern.
147. Asked why the prudential regulator had decided after the House of Lords' ruling not to require Equitable to close to new business, officer J said that this was because to do so would be very damaging to the value of the company, and possibly fatal to the prospects of a sale. A balance had to be struck between the interests of new and existing policyholders, and the prudential regulator had taken the view that the balance was overwhelmingly in favour of allowing Equitable to continue writing new business. If a sale had taken place as expected all policyholders - new and old - would have benefited from it. Furthermore, new policyholders could be compensated if they sustained loss as a result of joining on the basis of misleading information (under the conduct of business rules). If new policyholders had been aware of the risks, then that was a matter for them. Officer J said that it was fair to say that the collapse of the bidding process had occurred quite suddenly and until very shortly beforehand there had remained a realistic hope that a sale would go ahead.
148. As to the comment in the Treasury briefing of 6 December 2000 (see paragraph 100) to the Economic Secretary, which suggested a "deep-seated oversight" on the part of the regulator, officer J said that he did not accept that and in any case did not know what was meant by it. The prize of achieving a sale was of sufficient value to make it worth pursuing to the end. Asked about the contention in the Treasury note of the quarterly meeting on 13 December 2000 that neither Equitable nor FSA had recognised the extent of the GAR liability (see paragraph 101), officer J pointed out that the note was dated 9 January, some weeks after the meeting. He said that he had not seen the note previously, and that had he done so, he would have asked for it to be amended as he did not recognise or accept the substance of it in a number of respects. He did not, for example, accept the comment attributed to him in the note of the meeting in respect of the House of Lords' judgment being completely unexpected.
149. Officer J said that he did not believe that there was anything that FSA could have done differently that would have significantly altered the outcome of these events. The only other option would have been to close Equitable to new business after the House of Lords' ruling, which would simply have precipitated the situation that eventually transpired but which would have given Equitable no chance to try to save itself.
150. The Director with responsibility for prudential regulation told my staff that, in terms of the court action, FSA had identified a number of possible outcomes (including the eventual outcome); they had then done an initial analysis and had not thought that the eventual outcome was sufficiently likely that the regulator had to act as if it was the likely outcome. The outcome was in that sense unexpected - but not unanticipated. Equitable had taken advice and that advice had made them believe that the case was worth running, although they and FSA had recognised that all litigation was uncertain. The internal legal advice given to the regulator did not differ from that view.
151. The Director said that, when the unlikely outcome began to look likely, a colleague had met with Equitable who had said that they would seek a buyer. As long as a sale was a realistic option, FSA would not have wanted to frustrate it. There were other options open to the management of Equitable, including a moratorium on new business; Equitable could have restricted new business and re-balanced their portfolio. However, they had wanted to restore the bonus, which the other options would not have allowed them to do. If Equitable had been "a dog" FSA would not have let them proceed to a sale but, as matters stood, they would have struggled for grounds on which to close them. While it was true that Equitable had suffered something of a reversal in the courts and were paying more to some policyholders than to others, they had remained solvent and there had been many companies that had been interested in them. If then the business could not be sold, they would have been weakened, because they would have declared their hand, but would not necessarily have had to close to new business. It was not obvious, even at a later date, that closure was the right option. It was a balance between allowing policyholders to realise economic value in a sale with the relatively remote danger of the company becoming "a dead duck". He remained convinced that sale had been an appropriate strategy for Equitable to pursue. It had seemed a reasonably robust and sensible approach in principle. The primary obligation was on the company to decide their strategy, not for FSA to dictate to them. Their actions had been within the reasonable range of possible actions.
152. The Director went on to say that the prudential division had put effort into informing conduct of business colleagues about what was happening - communications between them had worked pretty well, especially in the case of Equitable. The prudential division's impression was that their conduct of business colleagues had looked at the situation and felt that Equitable appeared to be acting within PIA rules. Again, the conduct of business division had been left in no doubt as to what had happened in respect of the House of Lords' judgment, but there had been doubts about what that had meant for the future. Conduct of business colleagues had recognised that Equitable had been weakened, but took the view that, as Equitable were meeting the required minimum margin, then they would police Equitable's compliance with PIA rules in the ordinary way.
153. The Director was asked about the relevance to the failure of the sale of the company of the liabilities arising from GAR policyholders having the right to make additional payments to top-up their funds. The Director said that the two final bidders had both identified that they needed to do something about the
top-up liabilities, and indeed they had devised means to avoid or limit those liabilities (including the method ultimately employed by the eventual purchaser of the operating business) and had continued to engage in serious and protracted negotiations after learning of the issue. It was important to note that this liability was not in practice unlimited. The liability was self-limiting for a number of reasons, not least because there was a limit contained in the tax regime, but there was also the fact that policies could be taken on a single life only. The top-up liability had therefore been an issue, because there was a cost to capping the top-ups which meant that the price a potential purchaser would be willing to pay would be necessarily lower. A lower purchase price in turn affected goodwill because it reduced the sums available to be distributed to the policyholders; goodwill was one of Equitable's main assets given their client base. Thus, whilst the top-ups issue was a factor in the bidders' consideration of Equitable, it was a factor that affected the purchase price, rather than a factor which left an unquantified liability to be met by a prospective purchaser. It was therefore significant, but it had not been determinative. The bidders had withdrawn due to a combination of reasons, of which this had been just one factor amongst several.
154. The Director said that there was nothing that he would have done differently in relation to the sale process. He believed that none of the decisions the prudential regulator had taken had been significantly flawed.
155. FSA's relevant managing director said that it was not the regulator's role to tell a company what action they should take. In the case of Equitable's legal action therefore, the regulator's role was to see that the company had assessed the possible outcomes and the urgency with which they would need to act in response to each. Intervention by the regulator would be appropriate only if a particular proposed course of action would pose a serious risk to policyholders, and such intervention would be of benefit. They would also need to tell the company if any action proposed under the scenario planning would contravene statutory requirements, and to consider the suitability of any company proposing a take-over. It was his view that there was nothing that had not been done, either by Equitable or the regulator, that would have made any difference to the eventual outcome. Equitable's decision to sell following the House of Lords' decision had not come as a surprise to FSA and the prospects of a sale were seen as good. All professional opinion at the time was that a sale would generate a sizeable premium; Equitable had appointed a well regarded firm to advise on the sale; and it was known that a number of companies had expressed interest in buying Equitable in recent years.
156. The progress of negotiations was, from FSA's viewpoint, entirely what they would have expected. Although most of the 15 companies expressing an initial interest had dropped out, that was usual, and no more than two or three would be expected to reach the final stages. The managing director added that it was also to be expected that very difficult technical issues would arise at the later stages of negotiation, partly due to the progressively narrowing focus on increasingly specific aspects of transferring the business, and perhaps to apply leverage over the price or to obtain some form of regulatory concession. None of the potential bidders had been regarded by FSA as undesirable, although there were certain regulatory issues that would have had to be addressed had a sale gone ahead.
157. Asked whether Equitable's subordinated loan, reinsurance agreement, and future profits implicit items should have been seen as a sign of financial weakness, the managing director replied that that was certainly not so of the subordinated loan, as the ability to obtain such a loan could even be seen as a sign of strength. The reinsurance had resulted from pressure applied by the regulator and GAD to reserve more fully. He said that the future profits implicit items were slightly different, although he understood that no such application had ever been refused where the statutory criteria were satisfied. The concept had no parallel in any other area, but provision was made for it in EU directives, although it was to be phased out by 2009. FSA had inherited such concessions - final responsibility for which rested with the Treasury - as part of the regulatory system, and insurers expected to be able to take advantage of them. FSA would have needed to put forward a very strong argument if they had wished to refuse Equitable's applications when the concession had been granted so widely to others. The managing director concluded that there had been no real prospect of regulatory action against Equitable unless they had breached regulations. While he would have preferred to see them hold a substantial estate, their position had been entirely permissible within the regulations and provided no grounds for regulatory intervention.
Later developments
158. In a letter of 9 January 2003 the Director told my staff, in answer to their further queries, that in FSA's view, Equitable had to reserve on the assumption that close to 100% of [GAR] policyholders would take up their GAR option. He said that FSA accepted that reserving at a level that assumed 100% take-up could be excessive, given that take-up was very unlikely to reach this level. [According to Equitable, take-up at no time exceeded 50%.] At opposite ends of the spectrum were Equitable, who saw no need to reserve, and FSA who wanted reserving close to 100%. He said that a substantial body of opinion in the industry and the profession would have seen reserves at somewhere between 75% and 100% as appropriate. The Director concluded that it was fair to say that Equitable themselves believed that the position FSA took on reserving was wholly unreasonable. There was a body of opinion in other companies and among other actuaries that FSA's position was at the conservative end of the spectrum of views on reserving. My staff have received independent expert actuarial opinion that a prudent allowance for the GAR exercise rate would more likely have been in the region of 75%, maybe even a little lower. The limiting factors include contractual restrictions that applied within many policies when a GAR was exercised and taxation considerations. The latter would make it perverse for many policyholders to exercise the GAR in full even where the guaranteed rate was well in excess of current rates. Only when the GAR excess became very large would a higher range apply, reaching at its upper level to 90% - 95%.
159. In a further letter also of 9 January 2003, at the request of my staff, the Director followed up the point he had made at interview about the importance to the potential bidders of top-ups (see paragraph 153). He said that top-ups were a highly significant factor to potential purchasers. However they were not a "deal-killer". He said that the issue had been identified by potential bidders and advice had been obtained by the bidders as to whether the problem could be dealt with effectively. Some bidders had believed that they had devised workable ways of capping the top-up liability. This added to information in an earlier letter of 5 November 2002 in which the Director had said that, in November 2000, the potential bidders had devised workable plans to overcome the top-up issue as an obstacle to the sale, including the method ultimately employed by Equitable. He acknowledged that the relevant managing director's Board report of 15 December 2000 had put a greater emphasis on the ability of policyholders to top-up their polices as a reason for the potential bidders' withdrawal than had his own oral evidence. However, he still did not believe his account to be inconsistent with the contemporary documents. The additional cost to a bidder of capping the top-ups meant that they would offer a lower purchase price. This in turn would affect the goodwill that was one of Equitable's main assets. It was the effect of top-ups causing a lower purchase price rather than there being an unquantified liability to be met by a prospective purchaser that was significant.
160. The Director said that the key point in his view was that the final outcome of the combinations of factors leading bidders to withdraw could not have been, and was not, known to FSA any earlier than when the last remaining potential bidder [A] withdrew. On 6 November 2002 the managing director also wrote explaining that his Board paper of 15 December 2000 was not intended to brief the Board on the reasons for the failure of the sale process. He said that, had it been, he would have explicitly linked the top-up issue with goodwill and would have explained that other changes in the market place were also significant factors for bidders and part of the combination of factors causing them to withdraw.
Findings
161. My investigation has shown that when FSA began to operate as the prudential regulator on 1 January 1999 there were two key issues that they had to address in relation to Equitable. The first was the basis upon which Equitable were reserving for their significant potential liabilities arising from the GAR options contained within their individual and group personal pension plans. The second was the question of the legitimacy of the differential terminal bonus policy they had adopted to manage the actual GAR liabilities arising, and whether that could be said to meet policyholders' reasonable expectations.
162. The second issue had been taken out of FSA's hands to some extent by the time the Treasury handed over to them responsibility for prudential regulation, in that two significant events had taken place. First, on 18 December 1998 the Treasury had issued guidance to life companies (DD1998/5), which effectively said that operating a differential terminal bonus policy was not necessarily contrary to policyholders' reasonable expectations and could therefore be a legitimate practice. The factors which determined legitimacy in each case would be the wording of the contract involved and how that had been presented to the policyholders. That guidance was supported by GAD and the wider actuarial profession (the Faculty and Institute of Actuaries). Secondly, Equitable had already signalled their intention to test the legitimacy of their differential terminal bonus policy in court.
163. As for the reserving issue, the actuarial profession had become alert to the need to explore the nature of GAR liabilities and the approaches adopted by companies to reserving for them as an industry-wide issue only from late 1996/early 1997 onwards. That, at least in part, appears to have been due to the fact that the statutory regulatory system did not require GARs to be shown in the regulatory returns as an explicit liability until they obtained a clear value.
164. It was only therefore once interest rates had fallen significantly from those prevailing in the period when the Equitable GAR policies had been written (that is, up to June 1988), together with the fact that improving mortality required the revision of commonly applied actuarial assumptions, that the issue had become highly significant. (Appendix D demonstrates how rapidly the relative value of GAR policies was changing.)
165. The question of whether the failure to recognise earlier the particular relevance of the GAR issue in relation to Equitable could be described to any extent as resulting from a shortcoming of the regulatory framework in general, of that part of the legislation governing the regulatory returns, or on the part of one or more of any of the key players in these events - namely, Equitable themselves or their auditors, the actuarial profession or the relevant regulators and their advisers - is not a matter on which I can comment. The question relates to a period outside the timeframe of this investigation, but in any event all of those bodies, other than the Treasury and FSA as prudential regulators, and most of those matters (such as the relevant legislation) are outside my jurisdiction.
166. My investigation is concerned solely with the question of how FSA, acting as prudential regulator on the Treasury's behalf from 1 January 1999 onwards, responded to Equitable's position and the possible wider consequences for Equitable policyholders, and whether that response could properly be described as maladministrative and leading to injustice. All of that, however, has to be set against the backdrop of Equitable's then reputation and published practices. Equitable were a long-standing, successful and still growing company, which had a high public profile, were generally highly regarded and were seen as a market leader in the life insurance business. However, they were also unusual in terms of having no substantial free estate, together with a well-publicised policy of disbursing surpluses each year through annual bonuses, and had for many years in the past offered very generous and flexible GARs, which consequently represented a significant proportion of their business.
167. I have decided that the best way to present my consideration of these events and the conclusions I have reached is to look at how the situation in respect of Equitable developed, and how the prudential regulator responded, in relation to the different stages of the court action relating to Equitable's differential terminal bonus policy, which was the key issue driving these events.
