Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 20 - 39)



  20. Is the right date for alarm bells ringing in 1993, the date that current interest rates fell below the GAR rate for the first time?
  (Mr Headdon) That was the point at which something needed to be done to cope with the situation where the guaranteed annuity rates were higher than those currently available in the market. As I said earlier, the intended approach was to adjust the final bonuses to compensate for the higher value of the guarantees, and that was the approach that was implemented.

  21. Would it be right to say that everybody else felt that something must be done and they increased their reserves but you changed your policy on final bonus instead?
  (Mr Headdon) I think there is a great deal of lack of clarity as to exactly what bonus systems and approaches other life offices are following. I am afraid I do not have enough information about the market practice to answer that.

  22. We had information from the Annuity Bureau. They were discussing the consequences of your situation. They said: could such factors affect other firms? Yes. Could the same factors affect other companies that sold GAR polices? The scale of the problem is unlikely to be repeated as other companies have generally been more conservative in the distribution of with-profit current returns; i.e. they have higher reserves. Are you out on a limb as the only company that did not build up reserves?
  (Mr Headdon) It is clearly a truism that if a company has over the years distributed less than the full amount it could to policyholders and built up orphan assets, it has those assets available to meet contingencies. If you have not done that, you do not have those additional assets available.

  23. So you were out on a limb?
  (Mr Headdon) I said previously that I thought our approach was probably unusual. I was not sure that it was unique.

  24. In your submission to us you say: "The Society regarded its guaranteed annuity rate provisions as providing a minimum level of annuity or floor, below which the pension provided by the policy could not fall." Why did you regard the GAR as a guaranteed minimum annuity, that is to say the annuity rate plus the bonus, rather than simply minimum annuity rate, as the name says?
  (Mr Headdon) That is because that is how the contracts were designed and constructed. All with-profits policies provide a certain minimum level of guaranteed benefit, and that is an intrinsic feature of the contract. Typically it is a minimum cash sum that is payable at some future date. These contracts were unusual in that, as well as providing a minimum cash benefit, they also provided a minimum level of income. The guaranteed annuity rate was the technical mechanism in the policy that converted the cash into the income stream, but that is how the products were designed.

  25. In the House of Lords, Lord Cooke said: "This concept of asset share, which is nowhere mentioned in the policy, that dominates the approach of the directors ...." Do you accept, as Lord Cooke says, that there is nothing in the policy about your ability to do what you did?
  (Mr Headdon) There is nothing in the policy about final bonus additions at all. In fact, the contracts started being sold in 1957. Terminal bonuses were not actually introduced until the early 1970s and all the policies contain is the general provision saying that the policy may have bonuses added at the directors' discretion.

  26. What Cazalet said to us in another paper we received is quite simply: "The Society knew it could not afford to honour its guaranteed annuity options and accordingly sought to construct its bonus regime so that the guarantees would be worthless." Is that not what the House of Lords caught you out doing?
  (Mr Headdon) I think that is an unfair comment. All guarantees provide a minimum floor which, irrespective of the financial conditions at the time it was thought the benefits could become payable, provide a minimum level of benefit which the policyholder is assured of receiving. One could say that if an endowment policy matures and the payment out is twice the basic sum assured, that guarantee was worthless because the policyholder is getting substantially more. I think that misunderstands the nature of guarantee. As I said previously, in these contracts there were two levels of guarantee and in fact the guarantee in income form became increasingly valuable over the years and is more valuable to policyholders than the cash guarantee.

Mr Davey

  27. When you introduced your eventual bonus policy between different holders, GAR and non-GAR, did you believe that you had regulatory support for that?
  (Mr Headdon) At the time I do not think the regulator particularly commented. We believed it was consistent with the general practice, as I said previously, of having different levels of bonus between different contracts that had different guarantees. We were effectively translating that same principle into a policy where there were two alternative forms of benefit within the same contract, but it did not seem to us at the time a particularly radical or novel approach. It seemed wholly consistent with the general messages we had been putting out, that the purpose of the bonus system was, firstly, to deliver to policyholders their fair share of the accumulated part of the with-profits fund and, secondly, that the purpose of the final bonus was to lift the value of their guaranteed benefits up to that smoothed asset share. It seems a natural logic from those principles that, if you have a policy with two alternative benefits where the guarantees have different values, it leads you to assume that a different final bonus is appropriate to deliver a fair value of benefits at the end of the day.

  28. So when the board took that decision, it was not relying on any advice from regulators?
  (Mr Headdon) Not at that time, no.

  29. Did it seek advice from regulators?
  (Mr Headdon) No. I think the regulator normally regarded bonus decisions as a commercial judgment of the company. Provided they were recognising policyholders' interests fairly, I do not believe the regulators would have seen that they had a role in the detailed bonus mechanisms.

Mr Fallon

  30. I too declare an interest as a policyholder. Mr Sclater, do you recall the Treasury's letter of 18 December 1998?
  (Mr Sclater) Yes.

  31. Did you rely on that advice?
  (Mr Sclater) We had taken a lot of legal advice at that stage as to what our position was. We had always understood that our powers were very wide as regards bonus policy, particularly under Article 65 of our Memorandum and Articles. We found that that letter of December 1998 was consistent with the practice which we were adopting, as indeed was the subsequent guidance note from the actuaries, which came out, I think, in March or April 1999.

  32. So you relied on the Treasury's letter?
  (Mr Sclater) We relied on a number of things.

  33. I am asking you about the Treasury's letter.
  (Mr Sclater) That was a factor among others which we took into account in trying to do at all times what we considered best and fair by our policyholders.

  34. The Treasury advice was one of the factors that you relied on?
  (Mr Sclater) We received a letter. We were aware of the letter and it appeared, as I read it, to suggest that the practice we were adopting of paying differential terms and bonuses was in order.

  35. To that extent you did rely on it?
  (Mr Sclater) I can only repeat what I have just said.
  (Mr Martin) I wonder if I can help with this? It seems to me that it is a matter of timing. The differential bonus policy had been in force for some years by the time the letter of December 1998 was written. It confirmed in a modest way that what we were doing was not out of order. We had been doing it since the winter of 1993. Of course, by then, the issue had become a major one and we were litigating, or preparing to litigate.

  36. Why did you consider the possibility of the actual House of Lords ruling as, to use your words, Mr Headdon, "a very remote contingency"?
  (Mr Martin) I suppose there were several reasons. First of all, we had always been advised quite clearly that the House of Lords ruling was a remote possibility, unlikely. In the court below we had had a very strong judgment in our favour from Sir Richard Scott, the Vice Chancellor, now in the House of Lords. In the Court of Appeal we had a very strongly supported judgment from Lord Justice Morritt. It is true, of course, that Lord Woolf and Lord Justice Waller were against us, but we were reasonably confident when we went to the Lords on further advice that the finding that finally emerged was a remote possibility. There were other straws in the wind, of course. There was no doubt that the letter you have referred to was a comfort and there was comforting advice to the actuaries from the Institute of Actuaries, which also served to bolster what we thought was a strong position.

  37. But essentially you were gambling upon an interpretation of the law that had not been tested previously in the courts. Is that not the position?
  (Mr Martin) If you take the view that litigation is always a gamble, then we were certainly gambling. On the best advice, we took the view that the final result was a remote possibility.

  38. So you were gambling on the best advice?
  (Mr Martin) If you regard litigation as gambling, then, yes, but I do not think we were gambling. We were acting on good advice that our chances of going down were a remote possibility.

  39. Mr Sclater, in the 1999 accounts you refer to the potential cost as around £50 million to policyholders. Is that right?
  (Mr Sclater) As we understood it then, on the basis of the advice we had and the calculations that had been made, we estimated that to be the cost of meeting these guaranteed annuity obligations, that is correct. We provided a rather larger figure I think of £200 million in the accounts to err on the side of caution.

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