Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 220 - 239)



  220. The Government Actuary advised the FSA, as it does on most insurance companies, did it consider this scenario that the House of Lords judgment could be one of the possibilities?
  (Mr Roberts) Yes, we worked very closely with the Government Actuary's Department and they were party to our working up the various scenarios and the various contingency planning that the company might need to put in place against those scenarios.

  221. What was that advice?
  (Mr Roberts) It was more a question of an on-going dialogue. We were sharing the analysis and looking at what might happen and what might be appropriate. I do not think there was a single piece of advice.

  222. They did not assess this particular scenario in any depth?
  (Mr Roberts) They looked at all the scenarios, including this one.

  223. And what did they say? An actuary does not just look, he actually calculates and gives some results.
  (Mr Roberts) Essentially as my Chairman says, that in the, what we then thought to be improbable, event that the House of Lords would hold in the way they did hold, then an appropriate way forward was what the company itself proposed.

  224. Were Equitable unique in the life insurance industry in the approach they took to offsetting the effects of the GARs?
  (Mr Roberts) No, they were not.

  225. But then why were there disparities within the industry in this way? Is this a failure of regulation?
  (Sir Howard Davies) Disparities in what? In the treatment of GARs or in reserving?

  226. In the approach which was taken to offsetting the effects of GARs by reducing the terminal bonuses, for instance.
  (Sir Howard Davies) I think most people did take the view that some offsetting was possible.
  (Mr Roberts) I think there was a range of practice. Companies with relatively small GAR exposure and very large estates found it convenient to meet that exposure from the estate. Others in a different position took a different approach, and that was essentially a commercial decision.
  (Sir Howard Davies) It might be helpful if I say, as the Equitable pointed out, the value of these guarantees depends very heavily on the long-term interest rates in place at the time, and there is roughly a break-even point at somewhere between 8 and 8.5 per cent on long-term gilt rates where these policies trigger significantly higher annuities than you would otherwise have got unless you adjust the bonus. We have looked at this over a period of time—I don't know if you can see that[5], but if the squiggly line is below the straight line then these policies are in the money and obviously the further down that squiggly line is the more they are worth. They went into the money briefly in 1994 but then they came out again and they only became significantly valuable during the course of 1997 when long-term rates fell—and this line is January 1997—and started to fall very sharply. At that point, the insurance regulators and the Government Actuary's Department became concerned about how companies were handling the reserving for these policies given that they must now be quite expensive. The Government Actuary's Department on behalf of the regulators did a survey in 1998 of industry practice in relation to guaranteed annuities asking, one, how many have you got and how significant are they in terms of your fund, two, how are you dealing with the bonusing arrangements and, three, how are you reserving for them. That survey produced results over the summer of 1998 which was, if you like, the trigger for what I persist in calling Roger Allen's memo, where we looked at all this and discovered that while there were quite a lot of these guaranteed annuity policies in force, and mainly people were responding by adjusting the terminal bonuses, which did not seem controversial at the time. Companies were in most cases then reserving for the cost of these. They were able to do that because they were eating into their inherited estate, but Equitable stood out because it had, one, a lot of them because they had sold more of these policies than most people because they are predominantly a pensions house and they made a strong marketing effort in these between 1957 and 1988, secondly, they were particularly flexible policies and, thirdly, they did not have this carried forward "free estate", which again had been a strong part of their overall marketing. So they were uniquely affected, which was what led up to the debate with the Equitable from then on about how they should reserve. That is the sort of historical trail as to why we became anxious about it.

  227. In the light of that experience, is there now a case for regulation to create circumstances in which the reaction would be more uniform across the industry?
  (Sir Howard Davies) I think I agree with that and, indeed, efforts were made at the end of 1998 and carrying on through 1999 to give the industry much more detailed and precise guidance about how we wanted these to be reserved for in their statutory returns. There was a first approach by the Government Actuary, which was then interpreted in a slightly different way by different companies, and, secondly, the letter which gave much more detail. So we completely agree with that point and we have put in place such a regime.

  228. It is operative now?
  (Sir Howard Davies) Yes.

  229. Are you able to express confidence in the rest of the life insurance industry in the light of the Equitable events?
  (Sir Howard Davies) I am slightly reluctant, Mr Beard, to offer some kind of generalised comfort for a whole sector since economic circumstances can change, there can be ups and downs and life companies can perform better or worse. If I might turn your question slightly and say, does the Equitable case throw into doubt the viability of the whole of the with-profits sector, I do not believe it does, because I think the circumstances were somewhat unusual. The combination of having sold a large number of these policies, of having run with a lower level of reserves, the flexibility of the products, and being a mutual, all of these things came together to create a problem in the Equitable case, and we are not aware of any other companies, whether proprietary or mutual, which are in that same position. There are other issues going on in the life insurance sector, people are reassessing the profitability of the business, as the Prudential did earlier this week, changing their distribution systems, et cetera, and I expect we will see a lot of change in the with-profits sector going forward, and some of it I almost certainly will welcome. But this particular problem, to the best of our knowledge, is a combination of circumstances which is not repeated elsewhere.

  230. So effectively you are saying, I believe, that it is a unique set of circumstances?
  (Sir Howard Davies) Yes, we believe so.

  231. Is there though in the light of this, a case—or perhaps the regulations you are referring to already cover it—for some minimum ratio of free assets to be stipulated as a regulatory requirement?
  (Sir Howard Davies) We do have, of course, solvency requirements and we undertake resilience tests, et cetera, and it would be fair to say that the Equitable have met all of those requirements at all times. As to whether those requirements should be tougher, we will be consulting on the prudential regulation of life companies in the new regime, we will be consulting on different approaches to prudential regulation in the new regime, including looking at the question of interest rate risk, which is what this is, if you like, and how that should be reserved for, and I think the question of reserves should be addressed in that context and we will do so. I would not want to give you an instant answer to that, I am afraid.

  232. Would you also say that the regulations might cover the way in which risk is handled? It appears from the evidence this morning and from the papers we have got that, although there was passing reference to the possibility of the House of Lords judgment turning out as being the worst case, when provisions were made those circumstances were virtually ignored and the central case which was adopted by Equitable was the one against which everything was counted. There was effectively therefore very little risk assessment in the provisions made for Equitable.
  (Sir Howard Davies) There was I think quite a bit of risk assessment but risk assessment of the impact of changing equity values or changing interest rates, changing the take-up rates of guaranteed annuity policyholders, et cetera. It is fair to say they did not provide for a scenario in which the House of Lords overturned the basis on which they were making their bonuses.

  233. But that was the worst case, surely?
  (Sir Howard Davies) It was the worst case but we do not in this or other areas of financial regulation require firms to provide or reserve against the worst case. Frankly, if we did that, then banks would all have capital ratios of 100 per cent and there would not be any point in them being banks really. You always do a risk assessment, you look at a range of probabilities and determine an appropriate reserving level for insurance companies or appropriate capital levels for banks which gives you some kind of low probability of default. The system is built that way, it is not built to be a zero-failure regime, which is I think a point we have made to this Committee before. The only way you could have provided for the House of Lords judgment would have been to do what the company eventually did, which was to pass a bonus and make all the policyholders pay for the guarantee. That would be the only way you could have done it, and I do not think it would have been reasonable, based on the legal advice at the time, to have required the company to provide fully for that worst case outcome.

Judy Mallaber

  234. Can I return to Mr Fallon's earlier line of questioning. The FSA has been charged with ensuring that consumers receive clear and adequate information about services, products and risks. Do you think you ensured that happened in relation to Equitable Life over the last 12 months?
  (Sir Howard Davies) The statutory objective we have is to promote public understanding of the financial system. That statutory objective I have to say is not technically in force although we hope it will be later this year, and we are currently working on a variety of ways in which we would use that statutory objective to improve consumer education and consumer understanding. In the particular context here, we are carrying out a review of disclosure given at the point of sale to people who buy policies, and long-term savings policies in particular. That is a review currently under way and we have some consumer research to show that people do not well understand the information they are currently given when they take out these policies. So we will certainly be making changes in that area.

  235. Over the last period you have obviously wanted to ensure Equitable Life remained solvent and that also policyholders and potential policyholders have presumably asked for advice on the best course of action, how easy has it been to marry those two potentially conflicting sets of requirements?
  (Sir Howard Davies) I think that points to quite an important point which I should emphasise. The question of authorisation to do business in our regime—and this applies in banking and insurance and anything else—is, if you like, a yes/no question. "Do you meet our regulatory standards to do business?" If you are authorised to do business, either to take deposits if you are a bank or act as a stockbroker or write life insurance policies, you are not a-bit-authorised or given qualified authorisation or, "Authorised, but I wouldn't do business with them, squire". You are authorised or you are not, and the standards you have to meet are very clearly set out in terms of solvency requirements, fit and proper requirements, et cetera. They are clear and unambiguous. There is, however, of course, a whole other set of questions about the nature of the policies, the risks inherent in those policies, et cetera, which customers need more information about, but I think it is important to distinguish those two, and I do not think it would be easy for us to operate a regime—and I am not aware of one operated anywhere—where you say, "Yes, this company is authorised to do business" but then you require in its disclosure of information effective information which says, "I would not actually take out a policy with them, if I were you." You cannot have that. You are either eligible to do business or you are not. So what you must do in the disclosure is to set out the terms and conditions, the risks, in a reasonable and comprehensible way so people can make their own decisions. What we have been doing with Equitable policyholders has been to explain the pros and cons, to explain the nature of the problem, the nature of the case, and we have had that information available on our website, but we cannot give individuals advice on their personal circumstances.

  236. Returning to what Equitable Life were saying to me, I have a letter here from someone who invested £400,000 with them in June of last year, "... after supposedly seeking advice from several advisers, all of whom said they were unaware of Equitable problems", and that was just before the House of Lords case, and many other policyholders who took out policies after the House of Lords case are extremely angry, as you know. Yet Equitable Life was suggesting that policyholders should be able to base their decisions on what they had read in the press rather than themselves taking direct responsibility for giving that information without being asked to potential policyholders. Do you think it is appropriate for them to say that, or should they have taken greater responsibility for speaking to potential policyholders?
  (Sir Howard Davies) I am reluctant to comment too precisely on that question, for this reason, that we have received a number of complaints about policies sold in the year 2000, either between the Court of Appeal judgment and the House of Lords judgment or in some cases after. These are relatively modest numbers of policies, and after the House of Lords judgment there are about 6,000 policies out of a total of about a million in force in the Equitable. But we have received complaints about the selling of policies in the year 2000, both before the House of Lords and after, and we are carrying out a review of those selling practices during that period to see whether there is a case for action on misselling and whether there are investors who have been missold and who therefore should be compensated or given their money back. That is therefore a piece of regulatory action which is hedged around with all kinds of qualifications and constraints, and I would prefer not to say anything which implied the outcome of that regulatory investigation at this point.

  237. So you are not able to tell me if you think it was appropriate for them to carry on selling policies after the House of Lords judgment?
  (Sir Howard Davies) Yes, I can answer that question, because we did consider whether it was appropriate for them to carry on selling policies. We considered that it was in the policyholders' interests that they should do so, and we did not have any regulatory reason for them not to do so. However, the obligations on companies under the Personal Investment Authority's rules and on advisers advising—to give people good information and advise people on suitable policies and to set out the circumstances of the company—are there, those rules are in place, they have not been changed, they were not suspended for Equitable. Therefore what we need to look at is in that period, while we think it is perfectly possible for them to have continued sales, whether those sales were properly made within the terms of the PIA rules. That is what we are currently looking into and it is that point I would not wish to pre-judge.

  238. The steps that you took to advise current policyholders seeking to extend their investment and potential new policyholders of potential risks, and of the reduced freedom of Equitable in terms of future investment, that was done by virtue of the kind of newsletters and general advice you were giving out?
  (Sir Howard Davies) Yes, and various information on our website, et cetera.

  239. One final question, and you started to refer to this, obviously most people making savings and investment decisions do not have financial advisers and they are usually not well-versed in the ways of the financial markets, what lessons are you learning from the Equitable Life saga about how we can ensure people receive information in an understandable form and they are able to make informed decisions, given that this is not an area which most of us have detailed knowledge about?
  (Sir Howard Davies) We are undertaking a lot of work in that area, I would say, by no means specifically jumping out of the Equitable case, because we believe as a general matter that consumers do not well understand the risks inherent in many long-term savings policies. There is considerable evidence for that in the form of low persistency rates where policyholders buy long-term policies and then discover quite quickly they are not appropriate for their circumstances and then suffer a significant dead weight loss. So we are looking at ways in which we can improve the information to policyholders, we have also already talked to the Committee about our work on comparative information tables, which will be published during the course of this year, which set out costs and charges and particular features of policies in a way so that people will be able to compare, and by giving access to FSA comparative information tables they will be able to use them for their own circumstances. So we have an awful lot of initiatives going on in this area designed to improve consumer understanding of these policies. The Equitable case is I think a particular sub-set of that, but I am not sure what new issues it raises. We know we have a problem of poor understanding of the nature of long-term policies and the risks people run in taking them on.

5   See chart at p. 30. Back

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