Memorandum by The Equitable Life Assurance
Society
EXECUTIVE SUMMARY
This memorandum describes the actions taken
by the Society in connection with the guaranteed annuity rate
("GAR") issue. It outlines the reasons why the board
took the actions it did both before and after the decision of
the House of Lords on 20 July 2000. The board of directors of
the Society sought at all times to act lawfully by full compliance
with the relevant life assurance statutes and regulations, by
frequent liaison with the regulators and by the proper exercise
by the board of the powers granted to it by the Society's articles
and by law all in the interests of all members.
A BRIEF HISTORY
OF THE
SOCIETY
The Society was founded in 1762 and is the world's
oldest mutual life assurer. It has no shareholders. Its business
is conducted on principles of mutuality for the benefit of its
"members". Members are persons who have effected a "participating
policy", namely, a policy which confers a present entitlement
to participate in the profits of the Society—in other words,
holders of "with-profits" policies.
Before the decision of the House of Lords on
20 July 2000 the board of the Society adopted what it considered
to be a policy of "full and fair" distribution of its
surplus to with-profits policyholders. This policy was described
to policyholders at various stages over many years. In particular,
the explanation given made it clear that the Society did not therefore
build up an "inherited" or "orphan" estate.
This approach avoided cross-subsidy of one generation of policyholders
by another. In other words, if part of the surplus otherwise available
for distribution to policyholders was set aside for future emergencies,
this would have been at the expense of policyholders whose policies
were in force or maturing when those surpluses arose. In the view
of the board, such an approach would have been inconsistent with
full and fair distribution.
THE SALE
OF GAR POLICIES
The introduction of a new statutory pensions
regime in 1956 caused the Society to design a new form of with-profits
pension contract for the self-employed. This was novel and successful
and enabled variable contributions to be paid into it as incomes
varied from year to year and to suit the policyholder; Inland
Revenue maximum contribution limits applied if tax relief was
to be obtained.
The specific details of each class of policy
differ. However, they all provide policyholders with the right
to take the benefits of the policy at an age of choice, within
IR limits, either in the guaranteed annuity form of benefit written
into the policy or in "fund form" to purchase an annuity
at current market rates either from the Society or from another
provider by way of what is known as the "open market option".
This latter form of option was introduced into the Society's guaranteed
annuity rate ("GAR") policies following a change in
the relevant legislation in 1978.
Various classes of pensions policy issued by
the Society, and by most other life offices, included provisions
for guaranteed annuity rates ("GARs") The Society regarded
its GAR provisions as providing a minimum level of annuity or
"floor" below which the pension provided by the policy
could not fall. While the inclusion of such provisions was standard
industry practice, they were not used by the Society as a major
marketing tool. However, the Society was unusual, but not unique,
in not requiring policyholders with these contracts, the great
majority of which were with-profits retirement annuity policies,
to specify in advance when their benefits would be taken in the
future.
Pensions contracts containing GARs were issued
by the Society between 1957 and July 1988. No charge was made
for the inclusion of GARs. In July 1988 the new personal pension
policy was introduced to replace the 1956 Act retirement annuity
policies. No GAR was included in the new contract but the Society's
obligations in relation to GAR provisions remained and GAR policies
remained open for payments-in of further contributions.
It should here be noted that the interest rate
underlying the guarantee was 4 per cent up to 1975. The rate was
increased to seven per cent for policies issued between 1975 and
1988. Interest rates were well in excess of these levels in the
period from 1956 to 1988 and did not fall below 7 per cent until
late in 1993. Until then, current annuity rates exceeded GARs
and current rates were accordingly applied to the cash fund available
at the time benefits were to be taken from such contracts.
BONUS POLICY
FOR WITH-PROFITS
POLICIES
For the last 20 years at least, the board of
the Society, supported by actuarial advice, has taken the view
that each with-profits policyholder has a notional stake in the
overall with-profits fund and that the eventual benefits received
should, so far as possible, reflect the policyholder's share of
that fund. This was, and remains, the "asset share"
concept widely recognised by actuaries to provide equity between
policyholders—the essence of mutuality. This asset share
is made up of individual contributions to the fund and the returns
earned, after expenses, over the period of investment of each
contribution. To achieve the normal smoothing of with-profits
results, returns on invested contributions are averaged out by
the board on the advice of the appointed actuary when determining
a policy's accumulated asset share.
Depending on the kind of policy held, policy
benefits comprise a mixture of basic guaranteed benefits and annual
declared or reversionary bonus on those guaranteed benefits, to
which is added a non-guaranteed final bonus payable only when
the contractual benefits are taken. Final bonus is the means whereby
the Society sought to bring benefits into line with asset share
for all with-profits policyholders. Final bonus is not guaranteed
until policy maturity, and is payable at the discretion of the
board.
Traditional with-profits contracts carry a guarantee,
which is increased year by year by the addition of reversionary
bonus. If the value of the benefits on maturity as a result of
guarantees exceeds the asset share, the cost is met from other
sources—reduced bonus payments to other with-profits policyholders
or, in the circumstances of other companies, payments from inherited
estate or shareholders.
Contracts with GARs have guarantees expressed
in two forms, one expressed as a cash sum and one expressed as
a pension amount, each of which increases year by year with reversionary
bonus. These two guarantees will almost always have different
values.
The rates for annual declared reversionary bonus
have always been the same, whether benefits are expressed as a
cash value or as a pension amount. The purpose of the non guaranteed
final bonus before 20 July 2000 was to top up the value of the
guaranteed benefit to asset share.
Prior to 1993 the cash sum was higher. To avoid
penalising policyholders who took their annuity from Equitable
Life, the open market option (the cash value) was reapplied at
current annuity rates ("CARs") rather than being restricted
to the guaranteed annuity rate. In effect this was a differential
bonus rate, although not presented as such. This practice was
followed throughout the long-term insurance industry. For certain
periods after 31 December 1993, GARs exceeded CARs and there was
extra value attributable through the GARs.
The board decided at the bonus declaration at
the end of 1993 to adopt a "differential final bonus practice"
to equalise, so far as possible, the benefits taken by policyholders
in GAR form with those benefits in cash form. Using that approach
the cost of GAR provisions was estimated by the Society (at the
time the representative action was begun) to be £50 million
arising from the individual cases where the value of benefits
taken in GAR form was greater than the asset share.
The decision by the board to adopt the differential
bonus practice was made after a recommendation by the appointed
actuary and was seen as being consistent with the GAR policyholders'
policies and well within the wide and general discretion conferred
on the board by the articles of association of the Society.
THE REPRESENTATIVE
ACTION
Late in 1998, following complaints by policyholders
to the ombudsman about the Society's practice of awarding differential
final bonuses, the Society decided to seek guidance from the courts
as to whether its practice was lawful. It was apparent to the
board that if the ombudsman decided a case on the basis of the
individual circumstances of that case, the pressure to follow
the same treatment for all cases would be overwhelming—even
if the particular case decided had special features not applicable
to the portfolio of business in general. Certainty on the issue
was clearly in the interests of the Society and all its with-profits
policyholders. A representation order was made by the court: the
Society was appointed to represent the non GAR policyholders and
a Mr Hyman, separately advised, was appointed by the Court to
represent the GAR policyholders.
The case was heard at first instance by the
Vice-Chancellor, the head of the Chancery Division of the High
Court of Justice, who confirmed in September 1999 that the board
had discretion "well wide enough" to grant final bonus
of an amount dependent upon the form in which the benefits were
taken by a policyholder. Having considered all the relevant policy
documentation, he considered that there was no "policyholder's
reasonable expectation" ("PRE") that the same rate
of the final bonus would be applied to all policyholders. He also
held that there was "nothing contractually improper"
in the allotment of differential final bonuses. Finally, he confirmed
that the Society's approach did not deprive policyholders of any
part of their asset share. All seemed well.
Leave to appeal to the Court of Appeal having
been granted, the representative action went up to the Court of
Appeal which overturned the Vice-Chancellor's decision in January
2000 by a 2:1 majority. Lord Justice Morritt agreed with the Vice-Chancellor.
He held that, as a matter of contract, there was no promise given
to GAR policyholders that guaranteed annuity rates would be used
in the calculation of final bonus and that GAR policyholders had
not been deprived of what had been guaranteed to them, namely
payment of an annuity of an amount not less than that derived
from the application of the guaranteed rates to the accumulation
value of their premiums. He held that the board's discretion was
well wide enough to allow differential final bonuses, depending
on whether benefits were taken in GAR or non GAR form. Accordingly,
he rejected any claim that the Society had committed any breach
of the GAR policyholders' contracts. His approach was on all fours
with that of the Society.
Lord Justice Waller considered (contrary to
Lord Justice Morritt) that the Society was not entitled, as a
matter of contract, to adjust the final bonus of a GAR policyholder,
depending on whether the GAR policyholder opted to take a GAR
annuity or benefits in other forms. But he went on to express
the view that the Society was entitled to "ring-fence"
the GAR policyholders, and award lower rates of final bonus to
GAR policyholders (so as not to deprive non GAR policyholders
of their asset share). This was the so-called "ring-fencing"
approach. Although Lord Justice Morritt did not specifically deal
with ring-fencing in his judgment, ring-fencing would have been,
on the basis of his reasoning, an entirely legitimate approach
for the Board to adopt. Lord Woolf MR held that it was not a permissible
exercise of discretion for the board to award lower final bonuses
to policyholders taking benefits in GAR form.
It was estimated that, if the approach of Lord
Justice Morritt to the analysis of the GAR policyholder's contract,
or that of Lord Justice Waller to ring-fencing, had been upheld
in the House of Lords, the costs to the Society would be no more
than £50 million, for which there were adequate reserves.
Nevertheless a prudent provision of £200 million was included
in the Companies Act accounts for both 1998 and 1999 on which
the Society's auditors expressed a "true and fair" opinion.
The decision of the Court of Appeal did not
deliver the certainty which the Society sought through the representative
action. The conclusions and the reasoning of the three judgments
were each different. The Society was granted leave to appeal to
the House of Lords. While different possibilities were considered,
a ruling by the House of Lords that "ring fencing" of
the GAR policyholders was impermissible was viewed as remote.
In the event and much to the dismay of the board,
the House of Lords ruled unanimously on 20 July 2000 that different
levels of final bonus for those policyholders taking their benefits
at GARs compared with those taking benefits in cash or using the
open market option was an unlawful exercise of the board's discretion
and that "ring fencing" was impermissible.
THE JUDGMENTS
In order to understand what has followed it
is necessary to examine the House of Lords decision critically.
The principal judgment was that of Lord Steyn.
He held that it was not open to the Society to award differential
rates of final bonus. The essential steps in his reasoning were,
first, that it was an implied term of article 65 of the articles
of association that the Society would not exercise its discretion
in a manner which had the effect of undermining the GARs. This
principle was common ground between the parties. Second, and this
was the critical point, the purpose of the GARs was to ensure
that, if a fall in annuity rates occurred, the policyholder taking
a GAR annuity would be better off than he would have been with
market rates. In other words, he rejected the analysis of Lord
Justice Morritt, endorsing the Society's approach, that the GAR
benefit was simply a "floor" below which the pension
provided by the policy could not fall. He went on to hold that,
having regard to the purpose of the GAR benefit, "ring-fencing"
was impermissible.
The only other reasoned judgment was that of
Lord Cooke. He held that the assumption on which the GAR policy
was based was that, when current rates fell below GARs, the GAR
policyholder would receive higher benefits than if he had no GAR
provisions in his policy. He did not accept that the wide and
general discretion in the articles was adequate to justify the
differential adjustment of policy benefits.
OUR CRITICISM
OF THE
HOUSE OF
LORDS JUDGMENT
"Although it may be regarded as presumptuous
to criticise our court of final appeal, it is wholly proper to
do so. Judges as persons, or courts as institutions, are entitled
to no greater immunity from criticism than other persons or institutions.
Judges must be kept mindful of their limitations and of their
ultimate public responsibility by a vigorous stream of criticism
expressed with candour, however blunt."
We adopt, with approval and respect, the sentiments
of Justice Felix Frankfurter, one of the most famous of US Supreme
Court justices, as expressed in Bridges v California, 314 US 252,
289 (1941).
The judgment of the House of Lords may be criticised
in a number of ways.
The central point in the judgments was the finding
by the House of Lords that, as a matter of contract, the purpose
of the GARs was to ensure that, if current rates fell below the
GAR, GAR policyholders would be contractually entitled to receive
higher benefits than they would have done if they had not had
GARs in their policies. It rejected the argument advanced by the
Society, and approved by Lord Justice Morritt in the Court of
Appeal, namely that the GAR benefit only afforded a limited guarantee
whose purpose was simply to provide a minimum contractual "floor",
below which the value of benefits could not fall.
How did the House of Lords reach their conclusion
as to the purpose of the GAR? The House of Lords did not do so
on the basis of a detailed analysis of the terms of the GAR policy.
Indeed, Lord Steyn expressly took no account of the "minutiae"
of the policy. This is significant because the express terms of
the GAR policy did not, in the Society's view, support the House
of Lords' conclusion as to the purpose of the GAR. Lord Justice
Morritt endorsed that view. The policy wording did not show that
the purpose of the GAR benefit was to ensure that, if the GAR
was higher than the current annuity rate, GAR policyholders would
receive more valuable benefits than non GAR policyholders. Instead
of focusing on the wording of the policy, the House of Lords based
its conclusions as to the purpose of the GAR benefit on what it
considered to be the "reasonable expectation of the parties".
However, the Society considers that the House
of Lords' assessment of the "reasonable expectations of the
parties" was unwarranted and unrealistic. In the Society's
view, GAR policyholders had a reasonable expectation or "PRE"
that they would receive benefits which reflected their asset share.
The Society's view of PRE was consistent with, and supported by,
many years of unchallenged practice by appointed actuaries and
boards of directors charged with taking PRE fully into account.
In the life assurance industry, PRE is treated as synonymous with
asset share.
The House of Lords' assessment of the parties'
reasonable expectations appears to be based on speculation that
the GAR benefit must have been an important selling point in the
marketing of the policy. No evidence was before the House of Lords
to this effect. In reality, in the economic conditions prevailing
at the time the GAR policies were issued, the GAR benefit was
not considered to be an important feature of the policies. Many
policyholders would have been completely unaware that their policies
contained any GAR provisions and are unlikely to have had the
expectations found by the House of Lords.
The other main criticism of the House of Lords
we make is that, despite the fact that the House of Lords must
have appreciated it, judgments failed to take account of the impact
of their decision on the non GAR policyholders. It was, however,
repeatedly emphasised in the course of the proceedings by Leading
Counsel for the Society that the effect of awarding the same level
of bonus indiscriminately would be to enrich the GAR policyholders
at the expense of the non-GAR policyholders. Indeed, that was
clear and inevitable result of the House of Lords' decision.
In fairness to the House of Lords, of which
in this case we are unashamedly critical, it may be said that
if they were correct in the analysis of the contract, the prejudice
to non GAR policyholders is irrelevant. However, this seems implausible
since most House of Lords' decisions (and this is no exception)
are to some extent based on unspoken policy considerations, not
pure legal reasoning. That we can accept. But in this case, the
House of Lords appears to have bent over backwards to adopt a
so-called "consumerist" approach towards the most generous
interpretation of the GAR policy in favour of the GAR policyholders,
but, only in the absence of ring-fencing, at the expense of other
"innocent" consumers, ie the non GAR policyholders on
whom the cost of the GAR provisions would fall disproportionately.
In effect the House of Lords' judgment means that the final bonus
granted to GAR policyholders cannot be adjusted so as to ensure
that the GAR policyholders receive more than their asset share,
as would be the normal actuarial practice.
The result now is history. The board was, faced
with this decision, forced to offer the Society for sale to mitigate
the impact of the House of Lords' decision on non GAR policyholders
and also to mitigate new constraints on investment freedom caused
by changed reserving obligations. The sale process failed and,
in December 2000, the Society closed its doors to new business.
It was at all times and remains solvent—as to which more
below.
THE SUPERVISION
OF LONG
TERM INSURANCE
BUSINESS.
Monitoring the solvency of a long term insurance
business is not a simple matter.
The intrinsic profitability of the business
is not known until individual contracts have run their course.
In order to assess the position of the long term fund at any time,
it is thus necessary to conduct a valuation of the assets and
liabilities by making assumptions about the future economic and
business variables. There can never be certainty of the solvency
of a long term fund because, for example, a pandemic might cause
exceptionally high mortality rates resulting in almost any long
term insurance fund becoming insolvent. True insolvency, that
is to say, where the long term fund does not have enough assets
to meet its liabilities, is extremely unlikely in a with-profits
fund in the UK. After all, bonuses can be reduced or eliminated
so that only the basic policy guarantees remain and the fund is
able to pay at least these benefits.
THE SUPERVISION
SYSTEM
In the UK there is a complex system of supervision
which it is outside the scope of this memorandum to describe in
detail. The Insurance Directorate of HM Treasury/the FSA is the
regulator and the system also relies on the appointed actuary
of the particular fund. The concept of prudent actuarial reserving
with margins on each of the assumptions (compared to the best
estimate assumption) and imposing a supplementary reserve to provide
resilience to variability in the economic factors provides the
regulator with an early warning system so that failure to meet
the statutory reserving requirements occurs much earlier than
true insolvency. It is then possible for the regulator to arrange
a soft landing or to allow the company to trade its way out of
its difficulties. There is every reason to believe that this well
tried system has worked effectively throughout the past 25 years
as no significant UK life assurer has become truly insolvent during
this period.
DEFICIENCIES IN
THE SYSTEM
The system is not without deficiencies or imperfections.
The statutory basis can be too demanding for a with profits fund
at a time of abnormal market conditions. Virtually every company
would have failed to meet the statutory requirements had the current
regulations applied in December 1974, despite the fact that it
was perfectly possible to trade through those conditions (as the
companies did). The conditions of October 1998 also presented
very serious difficulties in terms of the statutory reserving
requirements. The undesirable side-effect of such a demanding
system is that at such times the appointed actuary may be obliged
to advise the investment team to sell equities and buy gilts at
just the wrong time. This is a well-known and well understood
defect in the system.
THE SUPERVISORY
SYSTEM AS
IT HAS
APPLIED TO
THE SOCIETY
In the autumn of 1998, the Society's management
attended a series of meetings with the DTI as the then prudential
regulator and with representatives of the Government Actuary's
Department (GAD). At those meetings the issue related to the Society's
approach to with-profits policies with GARs were outlined in the
economic conditions prevailing and with proper regard to ("PRE")
and the policy contracts. Reserving requirements were also discussed.
In December 1998 the letter from Martin Roberts
setting out guidance covering the handling of GARs was issued
to the industry, followed by the issue of new guidance on reserving
in January 1999 by the GAD. The Society's statutory reserves fully
reflected all the requirements in both 1998 and 1999.
The Society, although a mutual organisation,
has also chosen to comply voluntarily with the various corporate
governance provisions of the Combined Code. That it has done for
all relevant years and is fully compliant with the Turnbull recommendations
from the end of 2000.
5 February 2001
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