Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 180 - 199)



Sir Michael Spicer

  180. Sir Howard, in a letter to me dated 23 January this year, you said, "In the unlikely event of insolvency, there is a scheme designed to assist with the transfer of policies or arrange compensation". Does that mean that at the back of your mind there really is a possibility of insolvency in the future?
  (Sir Howard Davies) I think I was stating the factual position in response to an inquiry. I think I have in the back of my mind, in relation to all of the 10,000 companies I regulate, the possibility that they might become insolvent or go bankrupt. I hope, Sir Michael, you would think that I should have that in the back of my mind. As to whether it is in the front of my mind in relation to the Equitable—no, it is not, because at the moment the company is solvent and we can see a solvent way through for it. I think, however, for completeness one has to say there is a policyholder protection board which stands at the end of the line.

  181. Mr Sclater told us in answer to a question that I put to him that what he called technical insolvency was a possibility if the economic circumstances changed. Does that worry you?
  (Sir Howard Davies) Yes, it is true and, as he explained, there are two sorts of insolvency for life insurance companies. There is insolvency in relation to the statutory returns which is where we require companies to maintain a higher degree of reserves and, if you like, a higher degree of solvency—that is probably not the technical way of putting it but a higher cushion of solvency—than would be required according to company law. We are operating, therefore, above a cushion between our reserves and solvency law. At the moment they are above that and, at the moment, satisfactorily above that. Their solvency cushion above this minimum is not as great as some other companies, and any company which is clearly under some uncertainty—as the Equitable is with uncertainty about the outcome of a vote, et cetera—one has to have under particularly close watch. Indeed, we have a ratings system with the Government Actuary's Department whereby companies are rated according to the nervousness we have and the closeness with which we look at their solvency and the speed with which we analyse their returns, and the Equitable has moved appreciably up that table in the last couple of years.

  182. But both you and the Society representatives before us have said that, if economic circumstances change, insolvency—both true and technical—was a possibility, so does that not imply that the reserves are still potentially inadequate?
  (Sir Howard Davies) I do not think so because I think that the answer given by the Equitable and the answer that I would give would be that any life company could become insolvent in a particular combination of circumstances. Our regime protects—we hope—against most plausible economic circumstances but it cannot protect against all possible eventualities. Were the stock market to fall much further out of bed than it has at the moment and were long term interest rates to remain low or, indeed, get lower, then there could be circumstances in which the Equitable—and, indeed, other companies—would be in difficulty, but we do not foresee that at the moment. What I was saying for completeness in your letter was, were those unlikely set of circumstances to be the case, then there is the policyholder protection board which kicks in.

  183. Asset value is obviously one economic circumstance that could change; the other is that, for some reason not totally predicted by the Society, the with-profit policyholders could do a runner. That surely remains a risk, in your view?
  (Sir Howard Davies) It does and we monitor the performance of the fund very closely at the moment. We get regular figures from the company about the number of surrenders and the impact on the fund but at this point we are comfortable that that level of surrenders is not running at a rate which would threaten the solvency of the company, and we are content that the company meets all its statutory requirements at this point.

  184. Taking all your answers, do they not add up to a sense of uncertainty about the future so far as the Society is concerned? Is that perhaps not the real reason why you feel it needs to be sold?
  (Sir Howard Davies) Yes. There remains considerable uncertainty and I think that, without a sale involving some strengthening of the fund, that fund would, in order to maintain its solvency have to take a defensive approach to its investment management. I am certain it could maintain its solvency but it would have to do so, to put it simply, by buying fewer equities and more gilts in order to maintain the capital certainty of the fund and its liquidity. Over time, therefore, although the year 2000 was, of course, a notable exception, you could expect that that would produce lower returns because, over time, equity returns are approximately 2.5 per cent higher than gilt returns. The fund could, therefore, achieve a sustainable solvency but at the expense of future returns. If the Halifax deal goes ahead and the policyholders vote for a deal as put to them, then we think the fund could be solvent with a normal investment strategy, a normal proportion of gilts, and, therefore, it would be back on all fours with other closed funds. It would not be the same as an open fund because it would not be doing new business, but it would be back on all fours with other closed funds.

Mr Fallon

  185. Coming back to your duty as a regulator, you are required to ensure that the company had prudent reserves.
  (Sir Howard Davies) Well, we are required to ensure that the company's reserving meets the standards in force at the time.

  186. So you got it wrong.
  (Sir Howard Davies) No, we did not.

  187. If the company is put up for sale—
  (Sir Howard Davies) No. The company did maintain the reserves in line with the rules in force at the time but the House of Lords changed the circumstances, changed the interpretation of the law, which meant that they needed higher reserves at that point, at which point the company immediately put those reserves in place by passing the bonus for the first seven months of that year. So it remained consistent with our requirements, albeit it was achieved in this rather dramatic fashion.

  188. But why did you allow the Equitable to hide behind its own interpretation of the legal position?
  (Sir Howard Davies) We did not. As the Equitable themselves have explained, the bonus policy is a commercial matter for companies. Traditionally, regulators have not interfered in that. They took that bonus policy in the light of legal advice that they took at the time and therefore, from our point of view, we would check that a company was operating with good legal advice, and it did so. In addition to that, the letter that Martin Roberts wrote in December did reflect the view which the Treasury held at the time on the basis of its legal advice and which we continued to hold. The Equitable's interpretation of the discretion available to them was not inconsistent with our understanding of the law as it was.

  189. Once you were warned by insurance directorate about the information and their concerns about the information they had received, why did you not require the Equitable to ring-fence the with-profits fund once it was clear to everybody that the guarantees were going to be very costly?
  (Sir Howard Davies) That was not clear at that point because we were still operating on the basis that it was possible for the Equitable to achieve an equalisation of returns by adjusting the terminal bonus and the reinsurance policy was set in place against that legal background. It was that legal background that changed in July of the following year.

  190. So you do not accept there has been a regulatory failure?
  (Sir Howard Davies) In answer to the Chairman, I said that I think that it would have been better had a different reserving approach been in place in the past for companies writing open interest rate options and, therefore, if one could have one's time over again, that is what you would do differently. In the circumstances of 1998/1999, however, so far as I am aware, reasonable decisions were taken. I have to tell you, however, Mr Fallon, that this will be one of the core issues to be addressed in the review which is currently being carried out, and I am sure that that review team reporting to our full board will address that question. I hope you will not misunderstand me, therefore, if I give you my response to that, as I see it now, having lived through the period but others looking at it independently may reach a different view.

  191. But it is not a wholly independent review, is it? It is your own review.
  (Sir Howard Davies) It is a review carried out by a director of internal audit with external support from lawyers and accountants and will be reported to our board which, as you know, is dominated by non-executive members and will be published and I believe that will give an independent view of the events that took place.

  192. In effect, the FSA is reviewing whether or not its own position was reasonable. You are reviewing yourself, are you not?
  (Sir Howard Davies) We have set up procedures; we have accountability procedures for the FSA including a board which is dominated numerically by non-executive members; we have set up an internal audit and a quality insurance function which was partly in place in order to deal with questions where people raise issues about our regulatory effectiveness and, therefore, the board thought that was a reasonable response for us to take to what we have or have not done.

  193. Turning, finally, to the issue I raised earlier, you required in effect a £1.5 billion liability provision to be made against the guarantees in the returns. Why did you not require the Equitable to inform its policyholders directly of the position?
  (Sir Howard Davies) The way this has worked in the past, and I will at the end of my answer explain what I mean by that slightly qualifying point, is that this was disclosed in the statutory returns and therefore was, in the normal way, available in the public domain. Those statutory returns were looked at extensively by analysts, rating agencies, et cetera, and were the basis on which people produce league tables of free asset ratios and so on which are quite widely available in the public domain. This was the normal way in which regulatory requirements in relation to certain reserves would be made public and nothing different was done in relation to the Equitable at all. I think there is a question mark about whether there is sufficient clarity on the position of with-profits funds for with-profits policyholders. You may recall, Mr Fallon, that at my last appearance before this Committee in November I said we were contemplating doing some work on with-profits policies and a range of regulatory issues surrounding them, and I think the issue of the transparency of with-profits funds to policyholders and whether policyholders are, under the existing regime which I inherit, given the kind of information which is best suited to them and which most clearly explains the risks to which they are open is an interesting question and one at which we are actively looking. We are looking at whether disclosure to policyholders is adequate and whether the funds themselves are sufficiently clear, or not too opaque. There was nothing different done about the Equitable and that is the way it has always been done. Whether it is providing adequate information to policyholders for the future is an open question and one which we are actively looking at.

  194. But what was different, surely, with the Equitable was the difference in the amount? They were telling you that potential liability was £1.5 billion, and you were letting them tell their own policyholders that the maximum cost was only £50 million?
  (Sir Howard Davies) We have no control over the statutory accounts. The way insurance regulation works is on the statutory returns prepared according to insurance regulations, and they have always been describing a different picture from the one put out in the company accounts. I have to say this is the case for many other forms of financial regulation—the kinds of returns we require from banks and the kinds of reserving policy we require are different from the ones they present in their company accounts. Those returns have been well understood, however, by those who analyse the industry in the past and this change would have been well understood by the people looking at this closely—not individual policyholders but the analysts.

  195. But do you not have a duty not only to ensure that companies have prudent reserves but also an obligation to secure an appropriate degree of protection for consumers as part of your mission statement? Knowing what you did, you could have written to the Equitable requiring them to disclose this £1.5 billion liability to all their policyholders?
  (Sir Howard Davies) Technically I have to say that, while we do include our statutory objectives in our mission statement about our future ambitions, those have not yet come into effect. The Financial Services and Markets Act remains not yet implemented and, therefore, we are looking in this case, particularly if you are looking at the events of 1998/1999 at the regulations that were in force at the time and the duties on insurance regulators at the time. Looking forward, we certainly believe that an integrated approach to the regulation of life insurance companies incorporating both the prudential and the conduct of business side is required and, furthermore, that more and better information for policyholders is certainly necessary. That is a regime that we are currently working on; we have made some changes and improvements already and will be making more.

  196. But could you or could you not have required the Equitable to inform their policyholders of the £1.5 billion potential liability? You could have required them to do that had you chosen to do so?
  (Sir Howard Davies) Could we?
  (Mr Roberts) I am not sure we could. If I may say so, there are two separate points here: one is that we are requiring a reserve to be established against the possibility that, in extreme economic circumstances, the cushion of surplus assets over and above the contractual liabilities might no longer be available to pay out the guaranteed annuity rate. That was the potential liability against which we required a reserve to be set up. I think what the Equitable were saying in their accounts and what they said to policyholders in correspondence was that their estimation of the possible cost of losing their case on the GAR and non-GAR issue was what they said. Those are quite separate issues and I think there is quite a lot of confusion between them.

Mr Davey

  197. Following that, do you think there should be a change so that statutory financial provisions that are required in terms of yourselves are included in the accounts?
  (Sir Howard Davies) I am not sure that change would be possible because I think it would cut across the Companies Act under which the accounts are prepared, so I am not sure whether that could be achieved.

  198. But surely you could make that recommendation to government at least?
  (Sir Howard Davies) I imagine that we could and I think it is a point that we should look at. As far as the technical legal position is concerned, however, if this is of interest to the Committee I would be pleased to write to you about it. It came up in previous evidence, and it might be helpful.[2]

  199. Thank you. Going on to your discussions with Equitable before the House of Lords judgment was made, in the memorandum you sent to the Committee you said, "In advance of the House of Lords judgment, the implications of what subsequently proved to be its findings was one of the possible scenarios the FSA discussed with Equitable." How far in advance of the House of Lords rulings did those discussions take place?

  (Sir Howard Davies) They were between the Court of Appeal and the House of Lords. I cannot remember the precise date.

  (Mr Roberts) I do not remember precisely either. We did some internal work ourselves before the High Court to look at what the likely outcome might be. After the Court of Appeal, we got into quite a significant discussion with the Equitable to ascertain what their scenario planning was so that we might understand it so that there might be some arrangements already contemplated against the various possibilities that might emerge.
  (Sir Howard Davies) Our question to the Equitable was, as you would hope, "What will you do in the various circumstances, and then we can make a judgment as to whether that would be acceptable?" What they said in advance was, "If we go down in this unlikely event, we will announce that we are going up for sale and we will strengthen our reserves by passing the first seven months bonus"[3]. Our role was then to say, "Will that be enough to meet your solvency requirements and, in light of that, to allow you to carry on trading", and the answer to that was, "Yes". We regarded that as a response that was consistent with the regulations and appropriate in the circumstances. It was not our decision to do that but that was acceptable in regulatory terms and, therefore, we agreed with them that that would be what they would do. They, of course, did it immediately and so their regulatory requirements were met.

2   See p. 44. Back

3   Footnote by the Witness: Prior to the House of Lords judgement the Equitable told the FSA that, in the event of an unfavourable outcome, it would put itself up for sale and suspend the bonus payments on policies to ensure they were compliant. Back

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