Examination of witnesses (Questions 20
THURSDAY 15 FEBRUARY 2001
SCLATER, CVO, MR
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
(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
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'
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.
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.
30. I too declare an interest as a policyholder.
Mr Sclater, do you recall the Treasury's letter of 18 December
(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
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