Examination of witnesses (Questions 220
THURSDAY 15 FEBRUARY 2001
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
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
(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 timeI don't know if you can see that,
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 felland this line is January 1997and 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
(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
caseor perhaps the regulations you are referring to already
cover itfor 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
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
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 regimeand this applies in banking
and insurance and anything elseis, 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 regimeand I am not
aware of one operated anywherewhere 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
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
(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
advisingto give people good information and advise people
on suitable policies and to set out the circumstances of the companyare
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
(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
5 See chart at p. 30. Back