17 September '03 - The Parliamentary Ombudsman's report on the Prudential Regulation of Equitable Life

A paper for MPs on the select committees on Public Administration and Treasury, outlining why the Parliamentary Ombudsman's report should be rejected as deeply flawed.

Summary:

1) The Report does not cover the period when the most serious maladministration took place and ignores evidence of major financial irregularities

Equitable's fundamental mistake was made in 1975, when it started to issue Retirement Annuities Policies (RAPs) which guaranteed the policyholder a pension based upon long term interest rates of not less than 8% (the Guaranteed Annuity Rate or GAR). By 1988, when RAPs were replaced by Personal Pensions (PPPs), with no similar guarantee, almost all Equitable's With Profit policies were entitled to the GAR. Equitable made no provision to honour its guarantee even though interest rates had been falling for about five years. Instead it chose to mix the new PPP policies within the same single With Profits fund as the old RAPs. Hence, it exposed all new policyholders (for no recompense and without their knowledge) to the substantial risk of paying for the guarantees given to the older policies.

Throughout the 1990s Equitable Life voted bonuses on its policies, which were not covered by the value of its assets to the tune of £1 to £2 billion each year. This meant that its unduly rapid growth was based partly upon hot air, that it paid out, year in year out, far too much to departing policyholders and that its finances were chronically weak.

Successive regulators took no action to protect policyholders from either Equitable's inadequate provision for GAR costs or its repeated 'over-bonussing'.

For administrative convenience the Parliamentary Ombudsman has restricted investigation to the period from 1st January 1999 to 8th December 2000. This Ombudsman did not examine the decade when the most serious mal-administration took place. The matter of 'over-bonusing' was not even considered. The period was chosen expediently, simply because it was the 23 months evidenced comprehensively by the Baird report.

The Ombudsman accepted the FSA's explanation that by 1999 "the die was already cast". Indeed she used it to excuse the feeble behaviour of the regulators thereafter. But, irrationally, she declined to examine earlier prudential regulators' performance in between 1988 and 1998.

2) The FSA made a gross error of judgement which the PO excused, against all the evidence

The FSA, knowing Equitable Life's critical weaknesses, allowed it to continue to write new business both after the Court of Appeal and even after the House of Lords on the assumption that its goodwill could be sold for several billion pounds. In the event, Equitable could not be sold at any price (not even £1) and those that bought policies during the period of the FSA's supervision (like the complainant) lost substantially. The evidence shows that the FSA's over-confident decision was made without taking advice and even without proper consideration. Amazingly, the PO concluded that the FSA was not guilty of maladministration.

3) The PO was biased in taking evidence

The PO based her report on evidence from the regulators, their advisers, one unnamed actuary and from the FSA's own Baird report. However, the Ombudsman took no evidence from ANY of the 539 complainants, nor from academics, media, expert commentators or policyholder groups. As a result the report includes factual errors, such as criticising the complainant for not taking independent financial advice, which he had done.

4) The PO wrongly claims that the Government Actuary's Department (GAD) was not within her scope

The statutory power to regulate insurance companies was conferred on the Department of Trade and Industry and, from January 1998, on the Treasury. The GAD was a dependency of the Treasury, authorised to act on behalf of the prudential regulator and had no power to act other than as agent of the prudential regulator. Therefore, the GAD's acts and omissions were attributable to the regulator, from which it follows that the GAD's actions were subject to investigation by the Commissioner as if those actions were those of that regulator.

5) The Report uses the wrong yardstick

The PO examines the FSA's conduct of Equitable Life's regulation, not against the responsibilities imposed by the Insurance Companies Act 1982, but by the much less onerous ones contained in the FSA's secret, internally agreed Service Level Agreement (SLA) with the Treasury. Surely a Government department cannot dilute its statutory responsibilities simply by subcontracting its work? If the SLA was inadequate, is this not in itself maladministration?

6) The Report contains technical inaccuracies

The PO confuses the quite separate regulatory responsibilities pertaining to:

a) Technical Solvency - the comparison of assets with contractual liabilities (excluding terminal bonuses)
b) Policyholders' Reasonable Expectations (PRE) - in Equitable Life's case, the comparison of assets with policy values (including terminal bonuses) reported annually to policyholders.

7) The PO has refused to examine any further complaints about Equitable's regulation, regardless of the existing evidence or that which may emerge in the future, for example from Lord Penrose's Inquiry.

This totally unsubstantiated, irrational decision denies more than one million Equitable Life policyholders (and their MPs) access to the Parliamentary Ombudsman, to which they should be entitled, especially when Lord Penrose's Inquiry report is eventually published.

The PO's report on Equitable is an appalling piece of work, badly focussed, poorly executed and arriving at ludicrous conclusions. It is long on waffle and inter-departmental niceties and very short on logic, fair play and common sense.

The Real Story of Equitable Life

The Equitable Life Assurance Society, long regarded as the most stable, most venerated and most successful of pension providers, closed to new business on the 8th December, 2000. At the time it was assumed to be the result of a flawed strategy that the Society had discreetly pursued from 1993, relating to the treatment of Guaranteed Annuity Rates (GARs), that was eventually outlawed by the Lords.

Whilst there is no doubt that the House of Lords' decision contributed substantially both to Equitable's difficulties and to its inability to find a buyer, in the past two years it has become apparent that the Society was actually holed beneath the waterline for more than a decade with further hidden flaws.

EMAG commissioned a detailed forensic analysis of Equitable's financial accounts and actuarial regulatory returns by Chartered Accountants Burgess Hodgson. This revealed that Equitable's parlous state was brought about not only by the Society's exposure to GARs but also by a long-standing second flawed strategy, that of "over-bonusing", or overstating policy values, practised for more a decade. Equitable's own internal papers, revealed on May 25th, 2003 to the Court of Appeal by ex-auditors Ernst & Young, show the report's findings to have been conservative and the reality was even worse.
From the late 1980s the board of Equitable covertly implemented two high-risk strategies: not providing at all for the Society's GAR liabilities and voting bonuses in excess of assets. These were at variance with the board's oft-proclaimed policy of fair asset shares for all members of the With Profits fund. These strategies were hidden from members right up to and beyond the judgement of the House of Lords in July 2000.

The regulators however had ample evidence of the true situation every step of the way, from Equitable's annual actuarial returns and the also had the powers to take action, yet at no time, did they intervene effectively. Finally, in 1998, the regulators began to demand additional information, but by then it was too little, too late. As Sir Howard Davies stated in his direct evidence to the Treasury Select Committee (15th Feb, 2001), "the die was cast (before the FSA took over responsibility)".

Both of the disastrous strategies could and should have readily been prevented by competent and alert regulators. Sadly, successive regulators were neither. The result of the Treasury and the DTI's incompetence has been that all of the million plus policyholders remaining after closure have been made to pay of the order of £3 billion for both the "over-bonusing" and the mishandling of GARs.

The flawed GAR strategy

Equitable's big mistake started in 1975 when the GAR rates included in its policies were increased to effectively guarantee that policyholder's annuities would be paid on the basis of interest rates of about 8%, even if market rates were lower. By 1988, when Personal Pensions (PPPs) replaced Retirement Annuities (RAPs), virtually the entire WP fund was entitled to a GAR and by then interest rates had been falling for about five years. If interest rates continued to fall Equitable would not be able to meet its guarantees without a wholesale shift of its investment portfolio into gilts. Equitable made its ultimately disastrous decision relating to GARs when in 1988 it chose to mix new PPP policies within the same single With Profits fund. Hence, it exposed all newcomers to the long-term risk of having to meet the cost of all the earlier RAP contracts that enjoyed GARs, unlike their own policies.

The regulator appears not to have observed that Equitable had taken on an excessive percentage of pension business, that all its pensions contracts contained onerous terms which it had not made any provision to meet and that it was passing this massive risk on to unsuspecting new policyholders with PPPs. If the regulators subsequently became aware of this outrageous sleight of hand, they did nothing.

By December 1993 the board of Equitable had observed that long-term interest rates had fallen to about the critical 8% mark, when the GAR became valuable. A board resolution was passed to neutralise the extra cost, by the introduction of a differential terminal bonus policy (DTBP). Whilst policyholders were not told of this, it was communicated to the then regulator along with the 1993 regulatory return, but the regulators still did not spot what was going on. The Treasury Select Committee's 10th Interim Report in March 2001 commented on this failure.

Equitable still made no proper provision for the cost of GAR policies. When it was finally obliged to do so in 1998, at the regulator's very belated insistence, the liability had grown to £1.6 billion. Even then the Society countered the effect by financial engineering. It took out a worthless reinsurance contract, which it valued at £800 million. It included in the return £850 million of 'future profits' and its issued £350 million of subordinated debt, which did not count as debt! It also carried forward some selling costs as a form of Zilmerisation. Only by the application of all of these highly dubious devices was Equitable able to satisfy the regulatory hurdles to achieve technical solvenccy

The DTBP policy became significant when interest rates fell consistently below the 8% rate, from about 1995 onwards. In the late 1990s retiring policyholders observed that their contractual GAR was being neutralised by the DTBP device and many made complaints to the Personal Investment Authority. The society embarked on litigation to vindicate its DTBP, but the final outcome was the ruling on July 20th, 2000 by the House of Lords that the contractual GAR must apply to a policyholder's whole fund, including the terminal bonus. The cost ramification to the Society was quantified at about an extra £1.5bn. This came as a bitter shock to policyholders who had repeatedly been reassured by the society's managing director during the first six months of 2000 that the worst case result of the House of Lords would be an incremental cost of £50 million. The board of the society chose to immediately put Equitable up for sale. The House of Lords' ruling also came as a shock to the FSA, who had not taken advice on the possible outcome of the litigation and had no contingency plan.

An effective regulator would have insisted on a proper provision for the GAR cost from the late 1980's, when the downward trend in interest rates was established. This could have been calculated on stochastic principles using statistics and probabilities. The highly sophisticated methodology had been developed in the mid 1980s. The regulators should have outlawed the way Equitable passed the responsibility for the GAR costs to unsuspecting PPP policyholders. An effective regulator would have challenged the use of financial engineering and would have had some idea of available options in the event that Equitable lost - as the society did - in both the Court of Appeal and at the House of Lords. The DTI and Treasury were about as effective as car seal-belts with no anchorage.

The flawed bonus strategy

From about 1988 Equitable embarked on an idiosyncratic and dangerous bonus strategy that entailed running its With Profits fund without an 'estate' or even a 'smoothing kitty'. The policy was presaged in a paper titled "With Profits, without mystery", presented in 1989 to the Institute of Actuaries by Roy Ranson, the then appointed actuary of Equitable, and Chris Headdon who subsequently became managing director in 2000. Subsequently, Equitable made a virtue and a marketing tool of this hybrid new methodology which it described to policyholders as a "full and fair bonus" strategy.

This published policy would have been dangerous enough, but the Equitable directors actually geared up the risk by secretly and consistently voting bonuses that were not represented by adequate asset backing . Each year, through nine years of the rising stock market, Equitable's With Profit fund was actually in deficit to the tune of between £1 billion and £2 billion and only once achieved a surplus, briefly in 1993. Every year, all policy values were overstated. Policies on maturity or surrender were consistently paid more than their proper asset share when cashed in (even when non-contractually), in direct contradiction of the publicly declared strategy. Fresh capital streamed in to what was effectively a pyramid scheme. Aggressive direct marketing boasted about the Society's great performance (resulting partly from the "over-bonusing"). This succeeded in attracting very large number of new policyholders and an increasing flow of contributions from existing members. Equitable's growth throughout the 1990s was without equal. Growth came not through IFAs but through direct selling.

The Insurance Companies Act gives the regulator draconian powers to protect 'Policyholders' Reasonable Expectations' (PRE). In Equitable Life's case, there was no difficulty in defining what these were. Each year policyholders were informed of their policy's value (including terminal bonuses). This value was presented as the policyholder's 'smoothed asset share' and used as the basis for all pay-outs. If these were not policyholders' reasonable expectations, what were?

Indeed at the very top of the bull market (Jan 2000) they might reasonably have expected the directors to have salted away something for the inevitable 'rainy day', of the order of 5% of the £26 billion With Profits fund (£1.3 billion). In fact the fund was in deficit by about £2 billion. So it was then about £3.3 billion below policyholders' reasonable expectations.

All the time the regulators stood by and did nothing. This, in spite of the fact that the they were aware that the policy values provided to policyholders, used as the basis for pay-outs and publicised in the marketing literature, were not covered by asset value.

The first that policyholders knew of this "over-bonusing" was when their policy values were slashed by 16% in July 2001 - far more than the 5% that was needed to cover the cost of the House of Lords' decision. At the same time, the new appointed actuary reported that there was a shortfall of assets in his 2000 regulatory report to the FSA. Even then, policyholders had to wait until December 2001, when Mike Arnold, an independent actuary commissioned by the Society as part of the compromise scheme proposal, quantified this asset shortfall as of Dec 31st, 2000 at about 10% (or £2.6 billion). The FSA did not bring either of these ghastly revelations to the attention of policyholders or IFAs.
The fact that the deficit went back a decade was only revealed when Chartered Accountants Burgess Hodgson reported the results of their forensic analysis to EMAG in March 2003.
That report's figures also showed that much of Equitable's investment return had been taken up by prior claims of conventional annuitants and was not available to With Profit policyholders. Burgess Hodgson's findings of long-standing deficits were confirmed and shown to have been conservatively understated when Equitable's own figures were given in evidence in the Court of Appeal in May, 2003.

The Abortive Sale

With no advice and little thought the FSA accepted Equitable's directors' view that the value of its goodwill would be measured in billions. On the strength of this it allowed Equitable to continue its aggressive marketing, even though it lost in the Court of Appeal in January 2000 and again in the House of Lords in July 2000. Tens of thousands of innocent, unsuspecting new policyholders, including the claimant Mr P, lost substantial sums. The FSA was prepared to sacrifice the interests of investors in its misguided belief in the supposedly valuable 'goodwill' in the Equitable.

If the FSA had looked more closely it would have found that the GAR policies permitted incremental premiums to enjoy the benefit of a guaranteed annuity (GAR) at a far higher rate than could be obtained in the market. This made the GAR cost open-ended and impossible to quantify. This was in addition to the cost of the House of Lords' decision, the asset shortfall, the dubious financial engineering and the extra cost of GARs, which would rise with every percentage point fall in Current Annuity Rates (CAR). It did not take possible 'bidders" long to work out that whatever Equitable's £30 billion under management was worth as a business was more than wiped out by the cost of these flaws.

But the cavalier FSA did not bother to look closely and did not bother to do the sums. It took a several billion pound decision, got it horribly wrong - without any sort of 'due diligence' or 'know your client' procedures. This was maladministration on a mammoth scale.

The Parliamentary Ombudsman's Report

This is a pathetic document that does not begin to address what has been a sorry can of worms. Faced with the failure of the world's oldest Life company, the clearest evidence of serial regulatory failure over more than a decade and a huge error of judgement by the FSA based upon negligible consideration, The Ombudsman, Ms Abraham, retreated into the technicalities of inter-departmental buck-passing. She lost sight of the big picture.

More than one million people lost the best part of £3 billion. Faith in pensions has been dealt a life-threatening blow. All under the supervision of the Department of Trade and Industry, the Treasury, The Government Actuary's Department and the Financial Services Authority. And yet Ms Abraham could find no maladministration in the period she examined, refused to consider any earlier period and closed the door to any further examination of the regulation of Equitable, regardless of whatever evidence may be produced by Lord Penrose or others. She had the effrontery to blame policyholders for expecting too much! Do investors really expect too much when they assume that the regulators:

a) Know what major risks the companies under their supervision are running and what provisions are being made (or not made) to cover those risks?
b) Will not allow insurers to pass the responsibility for massive concealed risks to unsuspecting new policyholders?
c) Will not allow insurers to report policy values that substantially exceed the values of underlying assets?
d) Will insist that 'weak' companies strengthen their finances?
e) Will not make billion pound decisions without so much as a few sums on the back of an envelope?

Ms Abraham's report is a disgrace to the office and to Parliament. EMAG, on behalf of thousands of Equitable Life policyholders, calls upon MPs to reject it.

Chris Carnaghan, Colin Slater and Paul Braithwaite
EMAG committee members.
12th September, 2003