Week 6

Day 20 - Monday 16th May 2005

Sher for Wilson, a non-exec, continued to cross-examine Ranson

Ranson seemed unable to answer a number of questions.

Page 61 Rabinowitz for the non-exec Directors represented by Allen & Overy then cross-examined Ranson.

Page 68 Gaisman for E+Y cross-examined Ranson.

There is a marked difference between the approach of Sher and Gaisman.
Wilson, represented by Sher, wants to show that Ranson kept the Board in the dark about the realistic financial situation thereby casting Ranson as the villain. Gaisman for E+Y is trying to show that everything was perfectly normal and everybody did the right thing including themselves of course.

p.114 Hapgood took over for E+Y

p.157 Mumford for Ranson re-examined his client

Nothing of note the whole day except that Ranson thought the policyholders might possible have had the DTBP explained to them by the reps when advising on retirement.

Day 21 – Tuesday 17th May 2005

Milligan, for ELAS, cross-examining Headdon
(Although at times it seemed more like Headdon cross-examining Milligan)

This was really an interesting discussion between an expert Actuary and a knowledgeable novice discussing the finer points of the theory of managing a WP profits fund. What actually happened in reality did not enter the picture much.

Page 7: Milligan: One of the aims of smoothing is that policy

5 values should vary about a mean of 100 per cent of asset

6 values, is that right?

7 Headdon:. Depending on how one defines the assets, yes.

That deals with one major point. The value of your assets go up and down in line with the market and you try and aim for a smoothed line which is half way between the peaks and the valleys. Elsewhere it has been suggested that ELAS 'smoothed across the peaks' - that means that the line follows the peaks and eventually you run out of money.

The point is reconfirmed:

Milligan :In

17 other words, so far as the Society was concerned, for

18 part of the time, policy values should be above asset

19 shares and for part of the time below.

20 Headdon. That is correct,

Page 8: Headdon claims that the Society's smoothing was smoother than that of other companies:

Headdon: the practical

9 evidence is that the smoothing pattern followed by the

10 Society was not radically different from other offices,

11 and in fact, it tended to be somewhat smoother in its

12 progression from year to year,

Umm but if your assets are well below your policy values all the time and you are slowly (too slowly) trying to recover from that position your smoothing is likely to be a straight line as you slowly reduce the bonuses.

Page 10:

Headdon: there would appear to be something wrong

20 with your smoothing approach if you had got a persistent

21 occurrence of policy values well above asset values,

22 but, of course, in real life, unfortunately for

23 actuaries, the world does not necessarily behave as well

24 as that, and one has got to cope with the situations

25 that arise.

11

1 Clearly you are looking at the situation in the

2 1990s, with the two years of negative returns, and one

3 then has to look at what the expectations are that

4 policyholders have of the system, and smooth out the

5 effects of that as best one can, and hope that one will

6 bring it back into control in a reasonable timescale.

7 But, of course, in any year, one does not know what the

8 future holds.

Headdon is talking about the ideal situation and hinting at the real situation he was faced with when he took over from Ranson in the mid 1990s. He was handed a poisoned chalice where asset values were way below policy values and he had to try and recover from that situation. He did try but nothing like hard enough. Nothing of this is mentioned in Court though.

Milligan then drifted off into a seemingly irrelevant discussion trying to show that Mutuals with no estates would inevitably have smaller variations about the mean than a shareholder company with an estate. This strikes me as balderdash and I wonder whether he really has got a good grasp of what he is talking about. Just because you are aiming at 95% rather than 100% I do not see why the variation should necessarily be greater.

But just in case anyone has not understood what smoothing is about:

Page 15:

Milligan:. Just so far as this aspect of the business is concerned,

13 could you be given bundle C8, please, at page 69? There

14 you will find a letter from you to Ernst & Young on

15 3rd November 1995. In the second paragraph, you say:

16 "If one considers a with profits mutual which

17 operates on the revolving fund principle with no estate

18 and which aims for a full distribution policy, then on

19 average, policy values including terminal bonuses should

20 be above underlying asset values half the time. (They

21 would, of course, be below for the other half of the

22 time.) For such an office, that is what smoothing would

23 mean."

24 Pausing there, Mr Headdon, I think that reflects

25 what we have been discussing?

16

1 A. Yes, that is right.

2 Q. That remained your view throughout your time in office,

3 did it not?

4 A. Yes, as a matter of principle.

Let this be shouted from the roof tops for anyone to clearly understand what smoothing is about - there seem to be many who do not want to understand this. So how do you explain that ELAS, over a ten year period, was consistently way below policy values in its assets? Milligan of course does not point that out or ask that question.
There is then the curious position of the non-execs. In the next quote Headdon suggests that the non-execs should have asked about all this and should have been informed but nowhere does he say that they did ask or were so informed and Milligan does not query this for obvious reasons. Without seeing the documents they are referring to it is more difficult but here is the exchange.

5 Q = Milligan: . Over the page, the top paragraph:

6 "I think the issue in this area which the

7 non-executive director should be asking about is how the

8 level of free assets, be it positive or negative, fits

9 in with the office's smoothing strategy, and what is the

10 expected future development of the position."

11 Again, a reflection of your view throughout your

12 time in office, is that fair?

13 A = Headdon:. I think this is a comment about estates, is it not?

14 Q. Well, you tell me whether this is a comment which is

15 confined to estates, or whether it is a matter of more

16 general principle, and if confined in the letter, would

17 you nonetheless agree that it was true as a matter of

18 general principle?

19 A. I was just looking at the first paragraph of the letter,

20 which is the point I was actually responding to, because

21 clearly John had written some newsflash, and I am

22 responding to a suggestion that if your free capital

23 after a life of terminal bonuses is negative, you need

24 to do something urgent about it, and my response was, it

25 depends, you do not necessarily, because it may be

17

1 a natural product of your smoothing cycle.

2 Q. Yes, again, I think we are at one, and if you wish to

3 check, page 71 is the letter from Mr Bannon referring to

4 the newsflash.

5 A. Yes, it is not the newsflash, is it?

6 Q. But so far as page 70 is concerned, the top paragraph,

7 would you agree that it was important for the

8 non-executive directors to be informed as to the level

9 of free assets and how that fitted with the office's

10 smoothing strategy from time to time?

11 A. Well, I mean, I think what I am there saying is the

12 board should be briefed on the smoothing position,

13 whether you are ahead of the game or behind the game,

14 and if you are smoothing above asset share, and if it

15 had happened to be for one of the other reasons that

16 Mr Bannon was talking about in his newsflash, that is

17 something that one would need to talk about.

18 Q. That again was true, was it not, throughout your period

19 in office?

20 A. Indeed, yes.

I think he is saying yes to the question that the non-execs should have known, not that they did. It does show that Headdon is saying he inherited a situation and hinting he would not have started from there and a more coherent smoothing policy needed to be evolved.

10 Q. The only thing I think we do not see in this paper is

11 any target for deviation; is that a matter which you

12 used to discuss with the board from time to time, or

13 not?

14 A. I find that quite difficult to answer, because clearly,

15 I inherited a situation where we had come through this

16 period of two years of negative earnings, and my

17 immediate priority was to bring the ratio back into line

18 again, and that reflects the recommendations over 1997,

19 1998 and 1999, where in each year, we allocated less

20 than we had earned.

21 I think had other events not intervened, my

22 intention then would have been to develop for the future

23 a more structured, I think, smoothing approach, with the

24 sort of limits that we have talked about, and probably

25 by that stage, because we had increased our modelling

21

1 capability, we would be able to probably do annual

2 valuations of things like the embedded value of the

3 unit-linked and non-profit business and bring those into

4 account in a more formal way.

5 So I think -- sorry, to answer your direct question,

6 certainly during my period, I do not think I did discuss

7 a range, because my priority was restoring a position of

8 balance. I mean, I have not seen anything in the papers

9 indicating that Mr Ranson had promoted a particular

10 range in his day. I mean, I would be surprised if he

11 had not talked to the board in terms of plus or minus

12 10 per cent or something like that, again, as

13 an aspiration in relatively normal circumstances with

14 moderate degrees of volatility and investment

15 conditions. I am afraid I cannot give you a definitive

16 answer to what he may have said in that context.

So despite all this theory we are still in the dark about what if anything was ever said to the Board and the non-execs in particular.

The question remains as to why Headdon did not tackle the problem more strongly and Milligan does question him on this:

Q. Can I just take two points arising from what you have

18 just said? The first is that in the period up to and

19 including the commencement of the Hyman case, you had

20 enjoyed a bull run, so far as investments were

21 concerned, had you not?

22 A. Yes.

23 Q. And therefore, there was nothing unexpected which on

24 that basis interfered with any smoothing policy of, say,

25 three to five years.

24

1 A. No, but I mean, we were not starting at 100, were we?

2 Q. No, but if you are enjoying a bull run, that is the

3 ideal opportunity to allocate less in order to achieve

4 the target cycle.

5 A. Well, yes, if prior history were indifferent and one

6 were starting at 100, I agree that is the natural

7 reaction, but, of course, we were not, we were

8 recovering from the negative years.

9 Q. And a bull run is the ideal time in which to do so.

10 A. As we did, yes.

11 Q. Well, we will look at the question as to whether or not

12 you actually did. You certainly had not done so by the

13 end of 1997, had you?

14 A. As I say, I think if one brings the off balance sheet

15 assets into account, we were actually quite close by

16 then, and under by 1998 and 1999.

Headdon is complaining about his inheritance from Ranson. 'I would not have started from here'.

A reason given for his failure to tackle the problem more vigourously is the WP annuities and one can see his point. Someone who is building up his pension pot over the years is not going to be too fussed if one year the bonus is cut and later it is increased again. It has no immediate financial effect on him. However a WP annuitant is different as a cut in bonus could mean an immediate 10% cut in income for that year. Some were anticipating at rates up to 10.5%. Headdon felt inhibited therefore in making larger cuts in the bonuses. He illustrates this on page 29 talking about a bonus of 2% instead of 10%. But surely it would have been sufficient to cut bonuses by say 2% not 8% so this argument is a bit thin. But it is a valid point that WP annuities do influence the situation and perhaps points to them as being very unsatisfactory products.

We get to the point where Milligan says his argument (which I do not understand) that no estate means small deviations about the mean leads in the end to running a unitised fund:

Headdon:. I mean, if I could be excused for reversing what you did

11 a few minutes ago and pushing something to the limit,

12 the logical answer is you should never run with profits

13 business, you should only run unit-linked, so you never

14 have a smoothing cycle at all.

15 Q. I see the logic of that, Mr Headdon, but it goes back to

16 the point that the smaller your estate, the smaller the

17 deviation and the shorter the cycle that you can

18 tolerate. In other words, to take the extreme case,

19 a company with no estate cannot afford to do anything

20 other than run unitised business.

21 A. Well, whether it is estate or shareholder capital or

22 whatever.

23 Q. Subject to that.

24 A. Yes, I take that point.

25 Q. It demonstrates the point that I made to you earlier

41

1 therefore, that with next to no estate, you can only

2 tolerate short cycle/small deviation.

Page 55 suggests that the Office Valuation was produced at least monthly.

Page 116 we have some interesting discussion on the later products. This is what Penrose calls 'Technical innovation'. I would call it the swindle whereby new classes of product where introduced with no GIR and no declared or guaranteed bonuses - interesting point as to whether the policyholders was actually to be told about these new features or whether it was just to emerge later:

11 A. Probably product design as well, I probably ought to add

12 in.

13 Q. And a classic example of that would be for new products

14 having no GIR, which we know happened in the late 1990s.

15 A. Or no declared bonus.

16 Q. As a matter of interest, where you refer to no declared

17 bonus, do you contemplate that the policies themselves

18 would provide that there would be no declared bonus, or

19 merely that their expectations would be managed so that

20 there was no expectation of one?

21 A. I meant designing a range of products where there was no

22 declared bonus, so that the capital demands of the

23 products were less. That is something I actually did in

24 1998, I think, for one particular class of contract.

25 You have also reminded me of a further tool I had

116

1 forgotten, which, of course, is the declared bonus rate.

2 Q. I think to all of those, we are going to return.

Note that Headdon does not answer the question of whether the no declared bonuses should be written into the contract. We must watch for when Milligan does return to this subject.

Later on at page 169 there is a discussion about the Treasury's insistence that the extra money to support the GARs must be reserved for 100%. Headdon argued vigorously with the Treasury about this but here he seems to accept it as being correct:

3 Headdon: But sorry, I did not convince the regulator, I am

4 not sure I am going to convince you either. That is

5 where I am.

6 Q. At the end of the day, Mr Headdon, you are well aware

7 that that does not actually matter, it is his Lordship

8 that matters.

9 A. Indeed.

10 Q. If I can just pursue it a little bit further, you see

11 the intellectual justification for saying that there

12 should be a 100 per cent reserve for the guaranteed

13 floor.

14 A. I say I find that a more credible and coherent position

15 than what we actually got.

16 Q. Indeed, it is the only credible starting point, is it

17 not?

18 A. I do not agree with that. It is a point, I do not

19 think -- I do not think you can attach the label

20 "starting" or "finishing" to it, it is a view.

We end up not knowing quite what he is saying.
As I say - an interesting academic discussion of WP funds - probably there are points I have missed.

Day 22 – Wednesday 18th May 2005-05-30

Milligan for ELAS continues to cross-examine Headdon

Milligan takes Headdon through the history of ELAS but he jumps about and refers to documents often just by bundle and page number and as I have no access to those documents it is difficult to follow besides being highly technical.

Page 6. There is mention of overpayments coming out in a memo from Headdon to Nash of 29.8.1997 “Over the last search years, the accumulated excess of claims over asset shares is around £0.9 million”.

At one point the smoothing theory is reconfirmed – a sine wave.

Page 42. The story about the Treasury’s requirement to reserve for the cost of the GARs is revealed a bit further. We have known that at the end of 1988 the Treasury was asking for 100% reservation for the cost of paying a GAR on the guaranteed fund of a policyholder. The cost would be more than the guaranteed fund as CAR – current annuity rates – had fallen below GAR. The cost could come out of the final bonus but this was not reserved for and the Treasury said it should be to the extent of the extra cost of providing a GAR on the guaranteed fund – some £1.5 billion . ELAS took Counsel’s opinion on this – Grabinder and Green – who said the Regulators were wrong and told ELAS to threaten judicial review. ELAS tried this but the Treasury stuck to their guns at that time. What I did not know was that ELAS then went back to Grabinder who ‘ate humble pie’ and admitted the Treasury was right. He advised against a Judicial Review and told ELAS to go for reinsurance.

Reinsurance is discussed but not in terms of criticising it for merely being refinancing or overdraft facility and not insurance. Nor is the feeble attitude of the regulators allowing it to be used in the returns even though it was not signed until some 10 months later.

Page 50. The question that then arose was whether the reserve should be 100% or not. The FSA had now taken over from the Treasury and and was being very feeble. They would allow a few percentage points off but naturally ELAS took an ell.

Page 66. Discussion then developed about how much this reserve in the regulatory returns should be reflected in the Companies Accounts. Other companies were showing 80% of the reserve. ELAS went for 15% (page 67) but hoped it could be £50 million (page 68) and it ended up reduced to £20 million (page 72) – far cry from the £1.5 billion.

There was much discussion about the relation between the Regulatory Returns and the Companies Act accounts. Presumably the Regulatory Returns are there to ensure that the policyholders’ long term investments are adequately provided for. This is not some commercial company where one is looking at market predictions and what kind of profits could be expected in the future but a company safeguarding people’s life savings.

The Companies Act Accounts, however, appear to have been considered very much from the point of view of an ordinary commercial company. Can we meet our commitments in the next year? Can we just rely on things carrying on much as before – in respect of such things as take up of GARs for example? Reasonable foresight can be used instead of real provisioning for the future.

I can see that there is a case for arguing the Regulatory and Companies Accounts should differ. But it seems to me that they cannot be treated in isolation of each other as ELAS did. When drawing up the Companies Act accounts you are faced with the concrete fact that if the Regulators are asking for large provisions they are doing just that and if the company is unable to support those provisions then it is in danger of being closed for business. You may reasonably say that the provisions demanded by the regulators were excessive but if they cannot be challenged in terms of a misunderstanding of the regulations (i.e. judicial review) then you must look at them as an iceberg that could sink the ship. ELAS failed to do this or rather forgot to mention the fact in the accounts. This is surely where the accountants are at fault as well as ELAS.

Page 142. The use of future profits is discussed but not in the terms that it was an idiotic concept.

Page 147. Mention is made of the redesign of products with no declared bonuses in early 1998.

Day 23 – Thursday 19th May 2005

Milligan for ELAS continues to cross-examine Headdon

Page 8. A discussion of the mirror DTBP which operated up to late 1978 whereby annuities where topped up to CARs.

Page 10 We learn that Headdon drafted the resolution that introduced the DTBP in late 1978 but there was no mention of that being a continuance of the alleged mirror DTBP (page 13).

Telling the punters about DTBP was discussed.

Page 40: Headdon suggests: I suppose I could say that a policyholder that was sophisticated enough to think in option pricing terms would realise that the price of a dead short option was the full price.

No doubt!

The discussion goes on and on – basically no-one was told properly.

Page 60: Headdon in a memo at para 7 C20 page 64 to Bowley and a few others on 13th October 1998:

22 "The root cause of this issue is management's

23 failure to make sure that policyholders knew what we

24 were doing and understood why. Without too much

25 exaggeration, our approach can be characterised as

60

1 hoping that annuity rates would never go low enough for

2 the topic to become much of an issue and then putting

3 the minimum on annual statements to cover our backs but

4 without drawing too much attention to it. With

5 hindsight, the fact that we took action as early as 1993

6 on the bonus rates but annuity rates then rose so the

7 differential bonuses had no actual effect was a golden

8 opportunity to build understanding at a time when the

9 financial implications were negligible. That would have

10 enabled the ground to be prepared for a time when the

11 financial consequences were more significant."

12 Milligan: That echoes essentially what I have been putting to

13 you.

14 Headdon: A. I think I agreed that as an organisation, we had missed

15 an opportunity to describe the thing in early 1994, and

16 build understanding at that stage, and I mean, that is

17 what I am saying here, that with hindsight, and no doubt

18 Mr Ranson took the views he did on communication in the

19 circumstances at the time, but I think -- I detect

20 a note of irritation in my writing this, that the

21 current management had been presented with a problem

22 which, with hindsight, could have been avoided if there

23 had been fuller communication earlier, and I do not

24 disagree with that.

25 Milligan:Q. Furthermore, that had there been communication --

61

1perhaps we can leave that there.

One wonders what Milligan was going on to say – that they might have won the Hyman case if only they had told the policyholders about DTBP – but of course that is not the issue here!

Page 82: Once again we are told about how smoothing should have been (but wasn’t) trying to ensure … that the FFA is oscillating about the accrued terminal bonus

Page 106: For those who invested in the Managed Pension product with no guaranteed bonuses Headdon remarks:

“We had largely exterminated … guaranteed growth rates”.

Very appropriate word ‘exterminated’!

Well it certainly drags on – whether Milligan is building a case against Headdon I do not know – it certainly does not feel like those killer strikes one would have thought necessary.