Select Committee on Treasury Minutes of Evidence

Memorandum by the Financial Services Authority


  1.  The FSA welcomes the opportunity to contribute to the Committee's inquiry into regulation and management of risk in the life assurance sector. This memorandum:

    —  outlines the FSA's role in the regulation of Equitable Life from January 1999 to December 2000

    —  summarises the FSA's work since Equitable Life's closure to new business.

    —  outlines the FSA's plans to improve insurance regulation for the future.


B1  The FSA's Report on its supervision of Equitable Life

  2.  Attached at Annex A is a timetable of the main events over recent years. The Committee will be aware that on 22 December 2000 the FSA announced that it will produce a Report on its role in the supervision of the Equitable Life Assurance Society ("Equitable"). The Report will be prepared by a team led by Ronnie Baird, Director of the FSA's Internal Audit Department, with the support of legal and accountancy advice from Norton Rose and PricewaterhouseCoopers respectively. The Report team is accountable directly to the Board of the FSA, which is made up predominately of non-executive directors. The Report will be published. It is likely to take some months to complete.

  3.  The FSA expects to learn lessons from these events. It wishes to be as helpful to the Committee as it can at this stage, including by outlining the steps it already has in hand to improve insurance regulation for the future. However, in advance of the Report referred to above it would not be appropriate for the FSA to draw any final conclusions about the lessons to be learned or otherwise to pre-empt the findings of the Report.

B2  The FSA's responsibilities for the regulation of Insurance Companies

  4.  Following the Government's announcement in May 1997 of its plan to reform the structure of financial services supervision, Ministers decided that prudential supervision of insurance companies should be transferred from Government to a new single regulatory authority. In preparation for this, responsibility passed from the Department of Trade and Industry to the Treasury in January 1998. With the agreement of the FSA, Martin Roberts was appointed as Head of the Treasury's Insurance Division, with a view to leading the eventual transfer of the Division to the FSA. The Treasury and the FSA subsequently decided that, in order to facilitate the eventual full integration of supervisory functions within the FSA, the day to day task of prudential insurance supervision should be transferred to the FSA, ahead of the implementation of the Financial Services and Markets Act 2000 (FSMA).

  5.  Accordingly, from 1 January 1999 the Treasury's role in the prudential supervision of insurance companies was contracted out to the FSA, by order under the deregulation and Contracting Out Act 1994. Under the Order the majority, but not all, of the Treasury's powers under the Insurance Companies Act 1982 became exercisable by the FSA. Relevant Insurance Division officials, including Martin Roberts and Roger Allen, Head of the Department responsible for the supervision of life insurance companies, transferred to the FSA at that time. Throughout the months leading up to the transfer, Treasury officials had kept the FSA informed about significant developments in the insurance industry which were likely to be relevant to the functions which were to be transferred to it.

  6.  Following the transfer, and until FSMA is implemented, the FSA remains accountable to the Treasury for prudential insurance supervision.

  7.  The Government Actuary's Department (GAD) provides actuarial advice to the FSA to assist in this supervision in the same way as it previously advised the Treasury and the DTI.

  8.  The Personal Investment Authority retains legal responsibility for regulating the marketing of investment products by insurance companies including Equitable. Its requirements include standards for advertising and advice given to consumers at the point of sale. Whilst the work is carried out by the FSA staff under a service level agreement, the PIA continues to discharge its own functions.

B3  Guaranteed Annuities

  9.  When the FSA took on prudential supervision of insurance companies in January 1999, work was on-going on the guaranteed annuity rate (GAR) issue. A survey of GAR exposures across the insurance industry had been conducted by GAD in the summer of 1998.

  10.  This survey was conducted in order to establish which companies had an exposure to GAR contracts, as the transition to a low inflation environment led to these having greater significance. Equitable's response indicated that, although it had a substantial exposure to GAR contracts, no specific reserves were held to cover the costs of the guarantees. The Equitable explained this on the basis of its practice of paying different levels of bonus to GAR policyholders, depending on whether or not they exercised their right to the guaranteed annuity rate. Equitable had decided to pay those exercising the guarantee a lower terminal bonus, to the extent necessary to make the value of the guaranteed annuity no greater than the benefits that could be bought if the guarantee were not exercised.

  11.  Discussions between the regulators and the Equitable about the level of reserves required for its GAR exposure and the acceptability of its bonus practice in respect of GAR contracts were in train when regulation was transferred to the FSA in January 1999. Equitable established additional reserves of some £1.6 billion for its GAR contracts from the end of December 1998.

  12.  The GAD survey and subsequent discussions with insurance companies highlighted uncertainty within the industry about two issues: first, how the costs of GAR contracts should be met by companies and, second, the standard of reserving that was expected by the regulator.

  13.  In December 1998 Martin Roberts, then still Head of the Treasury's Insurance Division, issued a guidance letter to Managing Directors of insurance companies on the first issue. That letter was drafted on the basis of actuarial and legal advice at the time. The guidance was suspended in July 2000 following the House of Lords judgement.

  14.  In January 1999 the Government Actuary, in conjunction with the FSA, issued guidance to companies and their Appointed Actuaries on the second issue—the standard of reserving expected for GAR contracts.

  15.  During 1999 the FSA and GAD monitored companies' compliance with the guidance on reserving, primarily by review of their Annual Returns for 1998 (the bulk of which were received in June 1999). At the FSA's request, the Government Actuary issued further clarification of the reserving guidance in December 1999, as it was apparent from analysis of the Returns that there was some inconsistency in companies' interpretation of the January 1999 guidance.

B4  The Court Decisions

  16.  Throughout 1999 and 2000, the FSA followed closely the progress of the court case relating to Equitable's bonus practice in respect of GAR contracts. The FSA considered the implications of a range of possible outcomes of the case, including what was the eventual decision of the House of Lords, and encouraged the Equitable to develop plans for addressing these different outcomes.

  17.  The judgement at first instance supported Equitable's bonus practice—the Court held that Equitable could pay different levels of bonus to GAR policyholders according to whether or not a guaranteed annuity was taken up. As such the judgement had no financial implications for the company.

  18.  The Court of Appeal found that the Equitable could not pay different levels of bonus according to whether or not a guaranteed annuity was taken up. But it did not rule out the possibility that different levels of bonus could be awarded to different types of policyholder. One judge, Lord Justice Waller, said: "I see no reason why different bonuses may not be awarded to different types of policyholder and . . . why, for example, the board cannot in deciding what final bonus to award to GAR policyholders, keep that bonus at a level which does not deprive different with-profits policyholders of their equivalent asset share." Thus Equitable took the view, at the stage, that it could ringfence the costs of GARs amongst just the GAR policyholders, by reducing their bonuses as a class, and leaving the benefits payable to non-GAR policyholders unchanged.

  19.  The House of Lords judgement went further than merely upholding the Court of Appeal judgement. It ruled that when setting final bonuses the Equitable was not entitled to differentiate between policyholders depending on whether or not their policies contained GARs, or on the form in which benefits were taken.

B5  Implications of the House of Lords judgement

  20.  In advance of the House of Lords judgement, the implications of what subsequently proved to be its findings was one of the possible scenarios the FSA discussed with Equitable. The Equitable took the view that at current annuity values, the effect of this would be to increase the value of benefits taken in GAR form, and that these could only be paid at the expense of other policyholders. Moreover, the effect would be to require more funds to be set aside as reserves. As Equitable's policy had been to operate with relatively few spares assets, the company's scope to manage this without adversely affecting policyholders was limited. The FSA envisaged that in such an outcome Equitable would remain solvent and able to meet the statutory requirements, but it would be left in a relatively weak financial position and might need to seek a buyer. This proved in the event to be the case.

B6  Supervision of Equitable after the House of Lords Judgement

  21.  As a mutual, Equitable had limited options for rebuilding its financial strength in the wake of the House of Lords judgement. The company's response was to cut to zero the investment return paid to all policyholders for the first part of 2000 and, as discussed with the FSA prior to the judgement, to put itself up for sale. The FSA concluded that immediate regulatory action was not appropriate and, as indicated to the company prior to the judgement, the FSA allowed the sale to be pursued as a means of addressing the need to increase the company's financial strength. The FSA maintained close contact with Equitable during its search for a buyer so that any regulatory issues raised by potential bids for the company could be addressed at an early stage. The FSA also monitored the financial position of the company closely during this period.

  22.  In the summer of 2000 Equitable received 15 expressions of interest from potential purchasers and there was every expectation that a sale would be achieved. In December 2000, when it became apparent to the FSA that the prospects of a successful sale of the whole business were diminishing, the FSA held further discussions with Equitable. The company concluded that if no buyer was forthcoming it should close to new business. Accordingly, when the last potential bidder withdrew the FSA worked with Equitable to ensure that the decision to close to new business was announced in a co-ordinated way.


  23.  Since Equitable's announcement that it was closing to new business, the FSA has focused on six areas:

    —  monitoring Equitable's financial position;

    —  participating in sale discussions to address any regulatory issues arising;

    —  monitoring the terms on which policyholders can withdraw their funds;

    —  monitoring disclosure and advice by Equitable to potential and actual policyholders;

    —  monitoring the activities of other firms offering advice to Equitable policyholders;

    —  ensuring that policyholders have access to the information they need.

C1  Monitoring Equitable's financial position

  24.  It is not uncommon for insurance companies to close to new business. Currently there are 25 companies, other than Equitable, that have with profits funds which are closed to new business. Following its closure to new business Equitable has remained solvent and able to meet its liabilities to policyholders. However, the relative weakness of its financial position has resulted in a reduction in its investment freedom, and the company has begun to move to a more conservative investment strategy (which is normal for a closed fund). In December 2000 Equitable estimated that investment returns might be reduced by 0.5-1 per cent per year, once the change in investment strategy was fully implemented.

  25.  With GAD's assistance, the FSA continues to scrutinise the latest financial information provided by Equitable to ensure that prudent reserves are being maintained and that appropriate steps are taken to ensure that the funds of the Equitable are not exposed to undue risk. Insurance companies are required to maintain assets that exceed their liabilities by a specified margin, commonly referred to as the solvency margin. The FSA has regularly confirmed that Equitable continues to meet this requirement.

C2  Sales and other negotiations

  26.  Equitable made clear in the statement announcing its decision to close to new business that in order to secure maximum value for the policyholders, it would be looking to dispose of certain assets and business units that were not relevant to its continuing operations. Discussions with policyholders have also been taking place. Negotiations of this kind are primarily matters for parties concerned but the FSA participated in some discussions so that any regulatory concerns could be identified and considered at an early stage.

  27.  After holding detailed discussions with a number of potential bidders. Equitable announced on 5 February 2001 that it had concluded a sale of its operating business to the Halifax Group plc, in a deal worth up to £1 billion. The sale covered the sales force, the administration services, the management of the fund management business and the economic interest in the unit-linked and non-profit business (mainly term assurance) which will move to companies in the Halifax group. The sale does not cover the Equitable's with-profits fund which remains within a self-standing mutual, with the fund significantly strengthened by the proceeds from the sale. This element of the transaction is worth £500 million.

  28.  As a second part of the deal, Halifax has committed to make a further payment into the mutual, in respect of goodwill, of up to £500 million. This payment is conditional on a deal being struck between Equitable's policyholders that will enable it to cap the liabilities to GAR policyholders. Equitable intends to put to policyholders a GAR compromise scheme which, if accepted, would have the effect of further strengthening the fund and improving investment freedom and likely returns to policyholders. The scheme to buy out the GAR rights will need to be made on a basis that secures by vote the agreement of the different classes of policyholder. Court approval will be required.

  29.  The FSA has welcomed this deal as being in the interests of policyholders. Equitable is still working on the detail of the terms of the GAR/non-GAR compromise and the FSA will consider the detailed proposals in due course.

C3  Withdrawal of funds by policyholders

  30.  The FSA is carefully monitoring consumer reaction to Equitable's closure to new business and the basis on which policyholders are able to withdraw their funds.

  31.  As a matter of practice, life insurance companies typically reduce the amounts paid when a policy is surrendered other than on contractual dates. This is done be deducting some money from the funds being withdrawn. Life offices calculate surrender values in different ways. But in effect, each company sets the amount of the deduction, often referred to as a Market Value Adjuster (MVA), according to what it thinks is fair in the circumstances. Policyholders withdrawing funds on contractual dates (including retirement or other dates specified in the contract) are not affected by the adjustments.

  32.  The considerations that a life office takes into account depend on the particular circumstances of the company, the policies and the need to balance the interests of policyholders leaving the fund and those remaining. Other considerations include:

    —  the fact that the notional value of the policyholder's fund at the time of surrender may be higher than is actually justified by the investment underlying the policy;

    —  the need to recover expenses incurred when the policy was sold or set up on the company's administration systems. These expenses would otherwise have been recouped in future years;

    —  the need to prevent sales of the fund's assets at disadvantageous prices—which would lead to a poorer deal for policyholders staying in the fund.

  33.  Equitable announced on 8 December that following its closure it would increase the MVA to 10 per cent from its previous level of an average 5 per cent. At the time of writing this memorandum, the FSA understands that Equitable has no plans to change the level of the adjustment. On the basis of information provided to the FSA by GAD, it appears that even following the increase to 10 per cent, Equitable's surrender values are roughly in line with the industry average. The FSA is also satisfied that the level of MVA has been set in accordance with the criteria described in the previous paragraph. The FSA will continue to monitor the adjustments made by Equitable and has powers to intervene at any time, if it considers the adjustment to be unreasonable.

C4  The FSA's assessment of Equitable's disclosure and advice to policyholders during the period up to the closure to new business

  34.  Firms are under a regulatory obligation, imposed by the PIA rules, to ensure that information disclosed to consumers is clear, fair and not misleading. Advisers should use their best endeavours to enable consumers to understand the nature of any risks involved in an investment. During the period from the Court of Appeal decision in January 2000 to its closure to new business Equitable continued to advertise and advise consumers to invest in its with profits fund.

  35.  The FSA is carrying out work to assess the steps taken by Equitable to meet its regulatory obligations, in order to establish whether consumers were misled and have incurred loss as a result, and whether they should receive compensation. The rights of individual consumers will depend on the information and advice they were given at the time of sale. The FSA's work continues and includes an assessment of Equitable's handling of complaints by policyholders during this period.

C5  Monitoring advice to Equitable policyholders following the closure to new business

  36.  A key part of the FSA's work since the Equitable's closure to new business has been ensuring that policyholders have access to proper, clear information and advice. The FSA has worked with Equitable to make sure its own salesforce is available to advise clients appropriately.

  37.  The PIA has reminded advisers that all advice needs to be given on the basis of sufficient knowledge of the client's position and that all the relevant advantages and disadvantages of any recommendation need to be disclosed to clients and confirmed in writing. The PIA is examining approaches being made by other firms to Equitable policyholders and the advice they are receiving. This work includes the commissioning of a "mystery shopping" exercise involving Equitable policyholders seeking advice on what they should do. This will help the FSA understand whether advisers are meeting their regulatory obligations. If they are not, the PIA will consider action against the firms or individual advisers concerned where appropriate.

C6  Information for policyholders

  38.  The FSA has sought to ensure that Equitable policyholders have access to the information they need, including after the recent announcement of the sale to Halifax. The FSA has:

    —  produced an initial fact sheet on the company's announcement of its closure to new business—also available on its website—with information for policyholders who were considering whether they needed to take any action;

    —  provided information to policyholders—also available on the website—about the sale of the operating business to Halifax;

    —  handled Equitable-related enquiries through its Consumer Helpline;

    —  dealt with a substantial volume of written enquiries from policyholders;

    —  sought to reassure policyholders that Equitable is solvent and continues to meet the relevant statutory requirements for insurance companies;

    —  encouraged policyholders to seek financial advice before taking action;

    —  worked with Equitable to monitor the information it has made available at different times and to ensure that its communications to policyholders are written in plain language;

    —  monitored the adequacy of Equitable's enquiry handling arrangements.


  39.  This section describes a number of projects currently in hand which the FSA believes will, taken together, improve insurance regulation in the future. These steps reflect our general intention to move to a more proactive approach to regulation, focusing on the key risks to our statutory objectives.

D1  Supervision Resources

  40.  When the FSA took on the prudential supervision of insurance companies on 1 January 1999, the relevant officials from the Treasury's Insurance Division transferred to contracts of employment with the FSA. These included, in addition to the Head of Division, three Departmental Heads, nine managers, 31 associates and 17 support staff (secretaries and administrators) directly involved in supervisory work. These staff, with support from two advisers and 19 actuaries in GAD, carried out supervision of some 760 insurance companies.

  41.  Resources devoted to insurance supervision had increased significantly during the 1990s. Since 1 January 1999, the FSA has increased resource by a further 15 per cent. Nonetheless, we recognise that this area of the FSA's work is still comparatively under-resourced (by contrast, the FSA has some 21 managers and 114 associates who, with support from about 50 further staff in specialist teams, are responsible for the supervision of 398 authorised banks, building societies and UK branches of non-EEA banks). As indicated in the FSA Plan and Budget 2001-02, some further rebalancing of resources is planned in favour of insurance supervision, as well as significant changes in its organisation and the way staff work. These plans were made in the light of an assessment of the potential risk to the FSA's objectives posed by different classes of firm, which suggests that insurance supervision was relatively under-resourced, and is not specifically related to the circumstances of Equitable.

D2  Insurance Supervision

  42.  Historically, prudential insurance supervision has been based on:

    (a)  Public disclosure by companies of detailed, audited, financial information in annual statutory returns;

    (b)  For life insurance business, oversight of each company's financial condition, and control over the distribution of surplus, by the company's appointed actuary. The appointed actuary's functions are determined by statute, and are significantly buttressed by professional guidance and discipline;

    (c)  Desk based review (prioritised on a risk based basis) of the statutory returns by insurance supervisors (or, in the case of life insurance companies, by GAD actuaries);

    (d)  Discussions between insurance supervisors, GAD actuaries and companies as issues arise;

    (e)  Readiness to use statutory powers where needed.

  43.  As resources increased during the 1990s these activities were supplemented by more regular meetings between insurance supervisors and the senior management of leading companies, or of companies causing particular concern. By the time FSA took on prudential insurance supervision those visits were running at the rate of approximately 140 per year, of which about one third were focused on life companies. Our aim is to increase the frequency of such visits.

D3  Risk Based Supervision

  44.  In order to adjust to a rapidly changing (and increasingly competitive) insurance market and to prepare for the transfer of supervision from the Treasury to the FSA, supervisors have developed a more formal approach to risk-based assessment. This is now in use and encourages supervisors to consider a range of risks to insurance companies and their policyholders:

    —  financial risks—arising from capital adequacy and the valuation of assets and liabilities;

    —  external environmental risks—arising from economic and other developments;

    —  control risks—how firms organise and manage risks. (This has received relatively modest supervisory attention in the past.)

  This approach builds on the model developed over recent years for banking supervision and foreshadows the risk assessment framework described in the FSA publication, "A new regulator for the New Millennium" on which development work is continuing.

D4  Organisation of insurance supervision

  45.  As explained in the FSA's Plan and Budget for 2001-02, starting in April this year the FSA plans to integrate conduct of business (CoB) and prudential supervision of life assurance business. This will lead to a number of synergies between CoB and prudential regulation. The supervisory teams already need to consult each other extensively. This has been easier since co-location; full integration will help eliminate most of the remaining inefficiencies in this communication process. It will bring together both types of supervisor in the same team. It will be easier to share information between supervisors, and information requests made of firms will be tailored to suit the needs of both sets of supervisors. This will make the FSA's supervision of this sector more efficient.

D5  Actuarial Advice

  46.  Operational efficiency and flexibility will be further improved by the transfer in April 2001 of those GAD staff who currently provide the FSA with actuarial advice.

D6  Reviewing the prudential regime for all regulated firms

  47.  The FSA's further thinking on assessing the adequacy of firms' financial resources will be set out in the Integrated Prudential Sourcebook, which the FSA expects to issue for consultation during the second quarter of this year. This will impose a duty on insurers to make and justify their own assessment of the adequacy of their financial resources using appropriate modelling and other techniques including scenario and stress testing.

D7  Treating retail customers fairly after the point of sale

  48.  As part of implementing the new risk-based approach, the FSA announced last year that it would carry out a number of "thematic projects", reviewing major issues which cut across industry sectors and consumer groups and have wide-ranging implications for the FSA's ability to pursue its statutory objectives. One such theme is "Treating retail customers fairly after the point of sale".

  49.  This project is considering aspects such as:

    —  what powers and responsibilities the FSA has under FSMA relevant to treating customers fairly;

    —  how "fairness" should be interpreted for these purposes;

    —  circumstances in which unfairness may arise;

    —  current industry standards in this area;

    —  proposals for FSA work—in addition to projects already in hand—to address the risks identified.

  50.  The FSA is discussing its thinking with industry experts, consumer bodies, financial journalists and the Financial Ombudsman Service and expect to publish its conclusions in Spring this year.

D8  Improving the information available to consumers

  51.  In pursuit of its statutory objective to promote public understanding of the financial system, the FSA has a number of projects in hand to improve the information available to consumers, to help them make better informed investment decisions.

    —  In the summer of 2001 the FSA will launch a new Comparative Information service. This will provide an on-line service to consumers, giving them the opportunity to compare the features of financial products of specified types. A telephone helpline will offer this information to those without access to the Internet. The initial material will concentrate on long-term investment products.

    —  The FSA has published, both on its website and consumer booklets, a comprehensive range of generic information on financial matters such as FSA guides to pensions, financial advice and making a complaint. Over the coming year the FSA will be working, for example through post offices, to raise awareness of this FSA material.

    —  Following on from the FSA's discussion paper, "Informing Consumers", published last November, the FSA may consult later this year on proposed changes to the rules and guidance to firms on the information they must provide to consumers on packaged products. The aim is to assess the impact which the various disclosures currently required have on consumers, the burden which they impose on firms, and to consider how the disclosures might be expressed in a more meaningful way.

    —  At a more general level, the FSA plans to publish a statement "defining the regime" describing what consumers can expect from the regulator and from firms, and what will remain their responsibility.

D9  The implications of a low-inflation environment

  52.  A further thematic project on which the FSA is currently working concerns the implications of a low-inflation environment. In recent decades individuals and businesses in the UK have been accustomed to living in an environment of relatively high inflation. The long-term trend of falling inflation and falling investment returns has important general consequences for firms, markets and consumers. This development has been behind a number of policy initiatives across the FSA and is also an important backdrop to the Equitable case.

  53.  The FSA will publish its conclusions in a Paper in the Spring; this will highlight the risks the FSA sees arising—especially during the transition to a low-inflation environment—to its statutory objectives of protecting consumers, promoting consumer understanding and maintaining market confidence.

D10  With-profits review

  54.  A number of recent cases, including the Equitable, have raised important questions about with-profits products. In evidence to the Committee last autumn, the FSA indicated that it was minded to conduct a review of with-profits business. This work now forms one of the FSA's priorities for 2001-02.

  55.  With-profits products entail the exercise by companies of very wide discretion (for example of the way in which with-profits funds work, how bonus rates are set, how charges and expenses operate, how surrender values are calculated, and how "smoothing" works). The FSA wishes to examine the nature and extent of this discretion; and also whether with-profits products can be made more transparent to consumers, and if so how can this be achieved.

  56.  The FSA has already had preliminary discussions with representatives of consumers, the industry and the actuarial profession. These groups are generally supportive, and keen to contribute to the debate; the FSA wants to work closely with them in conducting the review.

9 February 2001

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