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Home > Publications > Special Reports - Parliamentary > The prudential regulation of Equitable Life > Summary
Part I:
Appendix: Summary of Findings Case No. C.1597/01
The complaint
1. Mr P complained to my predecessor that the Financial Services Authority (FSA), acting on behalf of the Treasury, failed to take appropriate regulatory action which would have ensured that existing and potential policyholders were able to make fully informed decisions when purchasing policies or annuities from the Equitable Life Assurance Society (Equitable). As a result, Equitable were able to continue to encourage him, and other investors like him, to purchase a with-profits annuity without a full understanding of the risks involved. He contended that, had he been aware of the true position, he would not have purchased such an annuity in June 2000. Having purchased the annuity, he was unable to transfer it to another insurer without penalty. He sought full redress.
The investigation
2. The investigation began in December 2001 after my predecessor had obtained the comments of the Permanent Secretary at the Treasury. On taking up the complaint for investigation, my predecessor decided to limit the period under investigation to that from 1 January 1999, when FSA began to conduct the prudential regulation of life insurance under contract from the Treasury, to 8 December 2000, when Equitable closed to new business. On taking up post in November 2002 I carried out a careful review of the position and decided not to depart from my predecessor's decision. I have, however, of necessity had to look back at some of the earlier events in some detail to understand the background to the period under investigation.
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Jurisdiction
3. The significant restrictions on my jurisdiction in this matter are set out in detail in paragraphs 3 to 6 of the full text of my investigation report (see Part II of this Volume). I should however emphasise here that FSA fall within my jurisdiction only in so far as they were acting on behalf of the Treasury as prudential regulator before 1 December 2001. I have no legal powers to investigate Equitable, the conduct of business regulators or the various professional bodies or advisers involved; nor may I question the merits of a discretionary decision taken without maladministration.
Evidence
4. During the course of my investigation my officers examined documents held by FSA, the Treasury, the Government Actuary's Department (GAD), and the conduct of business regulators in so far as they related to the prudential regulation of Equitable. They also interviewed a number of officers who had been involved with these events, including then members of FSA, the Treasury, and GAD. Equitable also submitted some specific papers requested by my officers. I have also obtained advice from an independent senior actuary. The detailed account of the prudential regulators' actions in relation to Equitable is set out in the chronology of events in Part II of this Volume; a summary of the officers' evidence is included in paragraphs 104 to 160 of the investigation report.
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Findings
5. I found that FSA as prudential regulator constantly had to assess and reassess whether they had grounds for taking formal regulatory action in respect of Equitable. As any intervention was likely to have a significant impact on Equitable's future profitability and even viability, and could therefore impact adversely on policyholders and would probably provoke legal challenge, it was not action to be taken lightly. Furthermore, Equitable were a long-standing, successful, high-profile and still growing company; they were highly regarded and a market leader. Although they were inherently weak financially, because of their policy of not holding back substantial free reserves and of distributing as much as possible to policyholders, Equitable had made no secret of that policy, which had been a key feature in their publicity and marketing strategy. The inescapable consequence of that policy, which they also publicised widely, was that policyholders would follow the company's fortunes. That relative 'weakness' was not of itself therefore a reason for intervention, as policyholders were well aware of it.
6. When FSA began to operate as the prudential regulator on 1 January 1999, there were two key issues that they had to address: first, the basis upon which Equitable were reserving for their significant potential liabilities arising from the guaranteed annuity rate (GAR) options contained within their individual and group personal pension plans; and, secondly, the differential terminal bonus policy used to manage the actual GAR liabilities arising, and whether that policy met policyholders' reasonable expectations. Either of those issues could have provided grounds for the prudential regulator's intervention.
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Regulatory solvency
7. There is no doubt that in late 1998 the Treasury had briefed FSA in considerable detail about Equitable's weak regulatory solvency position and had indicated a possible need for the regulator to intervene if Equitable either: a) continued to refuse to accept the need to reserve to the level GAD thought appropriate to cover the GAR liabilities, or b) declared a bonus without the regulator's prior agreement. However, that position stood to be resolved, at least to an extent sufficient to satisfy FSA's requirements in relation to reserving, by a reinsurance agreement Equitable were in the process of negotiating. By 1 January 1999, when the FSA took over as prudential regulator, the situation had therefore moved on sufficiently for the Treasury's earlier indications of a possible need for immediate intervention to be regarded as no longer valid.
8. Nonetheless, my investigation found that it was certainly not true to say that FSA knew that Equitable's position needed to be closely monitored and did nothing. The prudential regulators could certainly not be criticised for a lack of concern about Equitable and the position of their policyholders. There was considerable discussion about Equitable's situation and about the level of intervention required - and what could be legally justified - on the prudential regulator's part. There were also numerous exchanges and meetings with Equitable as FSA's prudential division, with GAD's support, tried to ensure that Equitable secured adequate reserves and did not worsen their solvency position.
9. FSA continued throughout to insist that Equitable conform to their full reserving requirements in the face of strong resistance from Equitable. They also strongly urged Equitable to be cautious about the bonuses they paid in 1999 (warning Equitable that they would use their powers to intervene if Equitable attempted to declare a bonus before FSA were satisfied that they had sufficient reserves in place). In March 2000 FSA did not query the 5% annual bonus declared, in contrast to the considerable wranglings of the previous year, but the bonus payment was in essence a commercial decision for Equitable (and fully in line with their publicised policy of maximum distribution of surpluses). As long as that did not cause Equitable to breach regulatory solvency (which it did not) then FSA had no basis for formal intervention on solvency grounds.
10. There was also the question of whether it was appropriate in the circumstances for the prudential regulator to allow Equitable to rely heavily on reinsurance and on a future profits implicit item (that is taking credit for anticipated future returns from current business) effectively to balance their books, given that these might be regarded simply as technical ways of satisfying the regulatory solvency requirements which did nothing to improve Equitable's underlying financial position.
11. Reinsurance was an accepted actuarial practice in the insurance industry, and GAD confirmed that it could be used to improve Equitable's regulatory solvency position. Given that advice, it was reasonable for FSA to accept the use of reinsurance in Equitable's case. Further FSA, working closely with GAD, took an active interest in the terms of the agreement and suggested to Equitable a number of amendments to the terms to make the reinsurance as robust as possible and, most importantly, to ensure that it was subordinate to policyholders' interests. Although the agreement was only signed some time after it was deemed to take effect, I received expert advice that that was not unusual within the industry and that the reinsurers would have been on risk (i.e. they would honour the agreement) once the terms had been agreed.
12. From 1994 onwards Equitable used increasingly larger future profits implicit items in their accounts. I accept FSA's view that the increase was broadly proportionate to the growth in Equitable's business and so did not necessarily point to underlying financial weakness. I note also that the most significant increase in the sum applied for was specifically to meet the prudential regulator's insistence that Equitable reserve fully for their potential GAR liabilities. Further, the sums sought were much lower than those for which they had been entitled to apply under the regulations. That being the case, again I do not see how the Treasury and their FSA advisers could reasonably have refused Equitable's applications. I considered whether a further application made shortly before the House of Lords' judgment in June 2000 should have attracted closer scrutiny in September 2000, particularly as the recommendation to the Treasury was based on advice to FSA from GAD which appeared to predate the Lords' judgment. However, I accept the accounts of GAD and FSA officers that they had reconfirmed that their earlier advice remained valid, and that the prudential regulator could not reasonably have recommended refusal.
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Differential terminal bonus policy and policyholders' reasonable expectations
13. Another possible ground for intervention was if the prudential regulator believed that Equitable were unable to meet 'policyholders' reasonable expectations'. This regulatory concept had no clear legal definition at the time and was not straightforward. There was no indication in the relevant legislation as to how companies were to balance the differing expectations of different groups of policyholders (for example, those of GAR and non-GAR, and of existing and new policyholders), particularly when meeting one group's expectations would impact adversely on the expectations of others. That balance was all the more difficult for Equitable, because they had neither significant uncommitted reserves (sometimes called free estate) nor shareholders to ask for more cash.
14. While FSA recognised that they needed to address the question of whether Equitable's differential terminal bonus policy met policyholders' reasonable expectations, they concluded that there would be little point in trying to reach a firm view on the matter until the court had given a final ruling on that policy. (Equitable had initiated a test case in the courts to determine whether they had the right to declare differential terminal bonuses depending on whether the policyholder took up a GAR annuity option or not.) FSA's decision to await the court's judgment was undoubtedly influenced by their view, in line with Treasury guidance of 18 December 1998, that there were legitimate arguments in support of the differential terminal bonus policy in certain circumstances. Was that so misguided a view that it might be considered to be maladministrative? I do not believe so. I note that the Treasury guidance made clear that the circumstances were dependent on the bonus policy having been made clear in the terms of the contract and on the life insurer concerned having communicated their policy clearly to policyholders. FSA took the view that, if that had been done, there could be no question of policyholders' reasonable expectations not being met. In my view, that was a reasonable view to take. Further, given the potential significance of the anticipated court ruling to the question of policyholders' reasonable expectations, and in light of the other discussions FSA were having with Equitable at the time, I consider that the decision not to rush to a firm view in advance of the court ruling was also reasonable.
15. The prudential regulator's decision to await the court ruling did not however mean that they did not consider the question of policyholders' reasonable expectations. FSA wanted to ensure that Equitable's financial position had not previously been, and was not then being, misrepresented to potential policyholders. To meet those concerns they pressed Equitable hard on the reserving issue and asked for early submission of their 1998 returns, in which Equitable were required to include specific reserves reflecting their full potential GAR liabilities. The prudential division also referred copies of Equitable's previous bonus notices, which they thought might be misleading, to the conduct of business regulator to determine whether they provided grounds for intervention by them.
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Should FSA have predicted the House of Lords' judgment?
16. In my view the fact that FSA did not consider the eventual ruling as a strong possibility, either from the outset or even after the Court of Appeal ruling, did not indicate that they were not carrying out their role effectively. The High Court had of course ruled in Equitable's favour, and further, each of the four judges who had considered the case up to that point had given different reasons for their conclusions. The Court of Appeal ruling had underlined that the issue was not clear-cut and had brought to the fore the issue of ring-fencing of funds, when one judge commented that in his view ring-fencing could be legitimate and would limit the financial impact of an adverse ruling. FSA did not seriously consider the significant ramifications if ring-fencing were not permissible until it became clear during the House of Lords' hearing that that ruling was a possibility. However, it would be wrong to say that FSA were totally surprised by the House of Lords' judgment or ill-prepared for it. The ruling was unexpected, but as it went against much accepted actuarial and industry practice, that was not in itself a sign of poor judgment; and the possibility had featured in both FSA's and Equitable's scenario planning. The fact that FSA's own legal advisers had raised the question of whether ring-fencing could be contrary to GAR policyholders' reasonable expectations might have alerted the prudential regulators earlier to there being a real possibility that the legal view might differ from the actuarial perspective. I do not, however, see that earlier serious consideration of the ring-fencing issue by FSA would have influenced events in any way.
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After the House of Lords' judgment (20 July 2000)
17. Equitable's solvency position (because the judgment affected the reinsurance agreement) and the decisions facing the prudential regulator changed dramatically after the House of Lords' judgment. FSA then had to decide whether to close Equitable to new business or to allow them to try to sell the company as a going concern. The prudential regulator's primary objective was to protect existing policyholders' interests by ensuring that Equitable remained solvent and able to meet their liabilities. FSA took the view that Equitable's strategy of seeking a buyer was likely to result in the best outcome for policyholders. Equitable said, and FSA accepted, that a sale could result in Equitable acquiring sufficient funding to repay the seven months of bonus withheld in response to the House of Lords' judgment, and possibly to make a goodwill payment to existing policyholders on top of that. That position could only be achieved - if at all - through a sale.
18. FSA's decision not to take formal intervention action at that time, but to allow Equitable to put themselves up for sale was reasonable as long as there was a good prospect of success. Equitable said, and FSA and many observers believed, that Equitable would easily find a buyer and command a substantial premium. While the regulator was well aware of the financial difficulties facing Equitable, I found no evidence to suggest that FSA should have either considered from the outset that the prospect of a sale was unlikely, or recognised significantly sooner that the sale process would fail. Given initial interest from bidders and Equitable's reputation, FSA could not have justified immediate closure as long as it appeared that the situation was still retrievable. While the potential liabilities arising from further top-up payments into GAR policies were undoubtedly a significant complicating factor, the fact that the three main bidders continued in the sales process for some weeks after they became aware of that issue strongly supports FSA's view that potential top-ups were not in isolation a 'deal-killer'. FSA's papers indicated that a combination of factors caused the bidders to withdraw, not all of which related to Equitable's finances; the bidders' own portfolios and business plans all contributed to their decisions.
19. That still left the question, however, of whether the prudential regulator should have stopped Equitable taking on new business after the House of Lords' ruling. FSA took the view that maintaining the value of Equitable was in the best interests of current policyholders, and that closing Equitable to new business would damage the Society's value and probably eliminate the prospect of a sale. That view was supported by professional advice I received. FSA saw a need to balance the interests of new and existing policyholders and had decided that the balance was overwhelmingly in favour of Equitable continuing to write new business as all policyholders - new and old - would have benefited from a successful sale, and Equitable's withholding of seven months' reversionary bonus meant that new policyholders were not being asked to subsidise the costs arising from the House of Lords' ruling. It was, and remains, the responsibility of companies to make explicit the risks to potential and existing policyholders. New policyholders could also be compensated, under the conduct of business rules, if they sustained losses as a result of joining on the basis of misleading information.
20. During the sales process Equitable launched an advertising campaign which was controversial. I found that the prudential regulator decided that, as Equitable were still meeting all the prudential regulatory requirements (and any intervention could have made the position for policyholders worse by reducing the prospects for a successful sale), they had insufficient grounds for formal intervention. They decided instead to bring informal pressure to bear on Equitable, which they did. That was a discretionary decision on their part which, given the circumstances at the time, I do not consider to have been unreasonable.
21. Similarly the prudential division took the view that they should not require Equitable to put a 'health warning' on their products. It would not be reasonable to allow Equitable to trade, but then suggest to potential policyholders and annuitants that the company was not a good investment. The prudential regulator had to have regard to the risks to new investors by requiring a company to close to new business if it was not, and had no immediate prospect of becoming, financially sound or meeting policyholders' reasonable expectations. However, the main concern for new investors would be if they believed they had been personally misled as to the state of the company - and that was a conduct of business, rather than a prudential, matter. In the circumstances, I did not consider FSA's decision not to require Equitable to make such a disclosure to have been maladministrative.
22. That raised the question of whether the prudential division had ensured that they had made the conduct of business regulator sufficiently aware of the financial difficulties which Equitable were facing, in order that they could reach an informed view as to what action would be appropriate on their part. I was satisfied that while, with hindsight, the prudential division might on some occasions have underlined even more strongly to their conduct of business colleagues the risks to new policyholders and annuitants if no sale was achieved, the prudential division had kept the conduct of business regulator adequately informed of Equitable's position.
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The Treasury's role
23. Although they had contracted out their prudential regulatory functions to FSA, the Treasury remained responsible to Parliament for prudential regulation throughout the period investigated. I was satisfied that the Treasury had retained sufficient in-house expertise in order for them to be able properly to monitor FSA's effectiveness in carrying out these functions to the standards set in the service level agreement. I was also satisfied that, although there was little documentary evidence of their routine contacts with FSA during this period, the Treasury had kept abreast of the developing Equitable situation and had had regular discussions with FSA about the prudential regulator's position.
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Conclusion
24. I have not found any evidence to suggest that the prudential regulator failed to take appropriate intervention action during the period under investigation. Nor have I found any evidence to suggest that the decisions which the prudential regulator made as to what action (both formal and informal) was required of them in relation to Equitable, were either outside the bounds of reasonableness or reached maladministratively. Given the then regulatory framework, the actuarial advice FSA were given, and the legal advice FSA received regarding the proper exercise of their powers, I do not dissent from their view that the prudential regulator could only intervene formally if a company breached the statutory requirements and that, otherwise, their role was to identify problems and issues, and through informal pressure, encourage the company to take the necessary action to get back to a sound financial base.
25. My investigation has shown that FSA monitored Equitable to ensure that they did not breach the regulatory solvency requirements and urged them to take steps to improve their position. They regularly considered whether they had grounds for formal intervention, thought through the likely impact of any regulatory action on policyholders and considered how policyholders' best interests were most likely to be met. While, with the benefit of hindsight, I have identified in my report several occasions when FSA in their role as prudential regulator might have done things differently, I have not found that on those occasions the action that they did take was in itself unreasonable (nor indeed that those actions influenced the overall course of events). I am therefore satisfied that the FSA, acting as prudential regulator on the Treasury's behalf, cannot be said to have acted maladministratively and to have caused the injustice which the complainant alleges. It follows that I do not uphold the complaint.
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