Members present:

                    Mr John McFall, in the Chair
                    Mr Nigel Beard
                    Mr Jim Cousins
                    Mr Michael Fallon
                    Mr David Laws
                    Kali Mountford
                    Mr George Mudie
                    Dr Nick Palmer
                    Mr James Plaskitt
                    Mr David Ruffley
                    Mr Andrew Tyrie

RUTH KELLY, MP, Economic Secretary, MR JON CUNLIFFE, Managing

Director, Finance Regulation and Industry, and MR ROBIN

FELLGETT, Director, Financial Sector, examined.


  86.  Good morning, Minister.  May I ask you to identify

yourself and your officials for the record?

  (Ruth Kelly) Ruth Kelly, Economic Secretary to the Treasury.

  (Mr Cunliffe) Jon Cunliffe, Managing Director of Financial

Regulation and Industry.

  (Mr Fellgett) Robin Fellgett.  I am Director of Financial


  87.  Thank you very much.  Did the Treasury in any way

attempt to modify or change the Baird Report before it was


  (Ruth Kelly) Not at all.  We published it exactly as it was

presented to the Treasury.  I do not think a word of the report

was changed in any way at all.

  88.  What other submissions to the Penrose Inquiry is the

Treasury planning to make, apart from the Baird Report?

  (Ruth Kelly) I think the Baird Report would clearly form a

significant piece of evidence.  It is up to Lord Penrose

himself within his terms of reference to decide what other

pieces of evidence he wants to see, so he will clearly be

calling witnesses and be examining all the written evidence.

If he wants us to provide any evidence to him then of course we

stand ready to do so.

  89.  I referred to Baird, paragraph 4.18.7.  That shows the

Economic Secretary to the Treasury of the Day in a very

perceptive light regarding the proposed Treasury guidance on

reserving for GAOs.  It is a fact though that over the

following months the Treasury did not change its advice but

managed to bring the Economic Secretary to the Treasury round

to its way of thinking, Baird 4.18.8-12.  In November 1998 your

predecessor expressed reservations about the proposed Treasury

guidance on reserving for GAOs on grounds that, perceptively,

anticipated the judgments of both Lord Woolf in the House of

Lords.  What were the arguments put forward by officials to

support the premise that policy holders exercising the

guarantee should suffer material reduction in terminal bonus?

  (Ruth Kelly) Chairman, you are asking for the justification

of the insurance guidance that went to the Economic Secretary

to the Treasury at the end of November 1998.  I think it is

fair to say, although I am not sure if this documentation is

not now in the hands of the Treasury but is in the hands of the

FSA, that the Economic Secretary to the Treasury then, Patricia

Hewitt, was not at first satisfied with the document with which

she was presented.  However, there was a clear call from the

insurance sector for guidance which the insurance regulators of

the time thought they had a duty to respond to in some sense.

What they made clear both to her and in the guidance was that

first of all there should be a charge, implicit or explicit,

associated with guaranteed annuities which could be reflected

in a lower terminal bonus; also that each life insurer would

need to consider the guidance in the light of its own documents

that it presented to policy holders, including how it presented

bonuses and so forth, and also that the guidance was not

prejudicial to any court proceedings which would ensue.  With

hindsight it is probably fair to say that the guidance was not

helpful in that situation.  There was a clear call from the

industry for a statement from the Treasury at that time which

it was thought wise to react to.  Of course what the Treasury

did was set out the opinion that was prevailing widely at that

time and, as I said, with hindsight it would probably would

have been preferable not to issue guidance.

                           Mr Tyrie

  90.  The Baird Report makes clear that there have been

regulatory lapses.  In the light of that is the Treasury

prepared to say today that it will consider compensation?

  (Ruth Kelly) I do not really see the Baird Report in that

light.  In some sense your question misconstrues the nature of

what the Baird Report was supposed to be.  The report itself

was always conceived first and foremost as an internal audit of

how the FSA was conducting its own stewardship of the

regulation of Equitable Life and the life assurance industry.

The author of the report, Ronnie Baird (and it is a very

professional report) clearly interpreted his terms of reference

in quite a narrow sense, to look just at how the FSA was

working.  In particular he did not see a need to go beyond his

terms of reference and look at the actions of the Equitable

Life itself, to talk to the Equitable Life or any of its

advisers, to look back in any sense deeply into the history of

the affair, so I see the Baird Report as, yes, significant but

necessarily a limited part of the overall picture.  I think it

would be unwise to draw too many conclusions from it.

  91.  I will abstain from drawing too many conclusions from

the Baird Report just for now.  What about Lord Penrose's

investigation?  Without prejudicing his inquiry do you think it

is possible that compensation issues may arise from the Penrose


  (Ruth Kelly) The terms of reference I gave to Lord Penrose

in August when it became clear to me that there were very

considerable issues at stake here.  I ought to use this

opportunity perhaps to say as well that I really understand the

plight that Equitable Life policy holders currently find

themselves in and I have great sympathy with them.  It became

clear over the summer that there were very deep issues at stake

here.  The purpose of asking Lord Penrose to investigate was to

make sure that the lessons were learned from the current

situation at Equitable Life and how it evolved, both the

conduct of the administration and the regulation of the life

assurance industry.  Clearly within this terms of reference it

is open to him to ask whatever questions he sees fit but I

would emphasise to you that this is a completely independent

inquiry, that I have no direct contact with Lord Penrose, I

seek in no way to steer or not to steer his inquiry.  It is up

to him how he pursues that line of questioning and how he makes

his own inferences from those.

  92.  I have asked you a very specific question about

compensation and you have given me a general answer about the

relationship between government and the inquiry.  Could you

have another go at answering the question which is of interest

to many policy holders out there, of whether the Treasury will

consider compensation?  You did not like my attachment of Baird

to the question of compensation.  The question of Penrose and

compensation has been moved into another pigeonhole.  We have

now got an inquiry by the Ombudsman.  Ombudsmen's reports

sometimes carry recommendations, they are not binding, they are

not statutory as they are in some other countries.  Will the

Treasury say now whether it will consider carefully any

recommendations (again without prejudicing his report) that may

come out of the Ombudsman's inquiry into maladministration?

Can there be any prospect of compensation by the Treasury in

this case?

  (Ruth Kelly) I would emphasise that both of those inquiries

are completely independent.  It is up to the authors and

investigators to decide what they recommend to the Treasury.

  93.  We are agreed on that.  I am asking you whether,

whatever they may say, it is possible that the Treasury might

consider compensation.

  (Ruth Kelly) Their terms of reference are clearly very

different.  Lord Penrose's terms of reference are clearly set

out as to learn the lessons from the Equitable affair, and I

think people can make their own minds up as to exactly ow he is

likely to interpret that.

  94.  Can you say whether that is a yes or a no?  I just want

to know whether the Treasury will be prepared to consider

compensation in this case.

  (Ruth Kelly) If the Ombudsman reaches a decision that a

grave injustice has been carried out for the policy holders,

then of course that is something we would look at.  If Lord

Penrose decided that compensation was within the terms of

reference of his inquiry and decided to go down those lines, of

course we would look at anything seriously which he proposes.

  95.  So you will be prepared to consider compensation in the

light of these reports?  Is the answer to that a yes?

  (Ruth Kelly) I think it would be ridiculous of me to

speculate on the outcome of those reports, but of course

whatever recommendations they put to us we will consider


                           Mr Laws

  96.  It is possible, is it not, Minister, that there could

be - and we obviously do not want to pre-judge Lord Penrose's

inquiry - one foreseeable outcome in the conclusion that there

has been gross regulatory failure?  That is a possibility, is

it not?

  (Ruth Kelly) Lord Penrose can come out with whatever he sees

fit and whatever conclusions he draws from the Equitable


  97.  You would open the possibility, would you not, that if

there were instances, not in this particular case but in

general, of gross regulatory failure, then there might be a

case for compensation?

  (Ruth Kelly) Clearly if people think there is a case against

the regulators it is always open to them to sue the regulators

directly and to test that in a court of law.  In fact, I

believe Equitable Life itself has engaged Herbert Smith, the

law firm, to look specifically at issues of culpability, so in

theory these options always exist.  What I do not want to do is

to try and speculate about how these inquiries are going to be

conducted and what conclusions they are going to arrive at.

  98.  Of course we do not want to pre-judge Lord Penrose at

all.  I cannot imagine Lord Penrose is going to come up with a

sort of 49.50 compensation figure.  He is presumably going to

look into these matters and conclude whether or not there has

been serious regulatory failure.  Once his report is out would

it then be open to people to go through the Ombudsman route if

there were to be a case for compensation, or would the Treasury

under those circumstances consider paying compensation


  (Ruth Kelly) The Ombudsman is an officer of the House, I

believe, and completely independent to pursue whatever avenues

he wishes to pursue.  I believe yesterday he has already said

that he will look at the post-1999 period of the FSA

stewardship in the light of the Baird Report.  As far as I

understand the position, he could equally at the moment look

further back into the history of the affair and pursue any

avenues he wished to.

  99.  His view of compensation is to a large extent an open

one and it is open dependent upon the results of Lord Penrose's


  (Ruth Kelly) I do not want to speculate on the outcome of

the inquiry or indeed the avenues that Lord Penrose himself

will wish to pursue.

  100.  It is an option that remains open if his report proved

that there was serious regulatory failure?

  (Ruth Kelly) The Ombudsman can choose to investigate at

whatever point he wishes to.

  101.  The Treasury must have been quite pleased, from a

glance at the Baird Report, to get the regulation of Equitable

Life off its hands in 1998/9.  When we look at the Treasury

report that was prepared and the briefing note that was given

to Howard Davies, Equitable Life sounds as if it was in a

pretty awful position.  The memorandum in October 1998 said,

"Meeting the cost of guarantees is putting significant strain

on the company's resources.  It is feasible the company would

have to consider some form of demutualisation."  The briefing

note that was given to Sir Howard Davies when the FSA were

about to take over in late 1998/early 1999 said that the

information received to date is unconvincing about Equitable

Life's reserves and raises serious questions about the

company's solvency.  Are you happy that this company continued

to take on new business in this transfer period between the

Treasury and the FSA?

  (Ruth Kelly) You are asking me specifically about 1998 and

how the Treasury handled the regulation in that period.  It

became clear in the summer of 1998, after the government

actuary's department had received its initial responses to a

survey of the life assurance industry, that Equitable Life had

a very serious exposure to guaranteed annuities.  In addition,

it had made no provision, no explicit charge and no reserves

against those options being exercised.  Clearly, that posed a

major regulatory challenge to the Treasury and subsequently to

the FSA.  In the latter half of 1998, I think the report shows

that, first of all, the problem was recognised; secondly, that

the government actuary's department and insurance regulators

attempted to get Equitable Life's reserves in full for these


  102.  Did the Treasury consider stopping new people from

joining Equitable Life at that time?

  (Ruth Kelly) Let me start with a caveat.  We no longer

retain the documentation for that period at the Treasury.  When

we decided to contract out the regulation of life insurance and

to create a single regulator at the beginning of 1999, not only

did we transfer the insurance regulators to the FSA but we also

transferred the knowledge and documentation.

  103.  You must know whether the Treasury considered

contemplating stopping new policy holders at that stage.

  (Ruth Kelly) I am just saying this as a caveat.  What I am

relying on, from my knowledge of this era, is the Baird Report

itself and the statements of fact which are in that.  It is

clear to me and to Members of the Committee that briefing notes

were prepared which suggested this as an option.

  104.  Why was that not pursued?

  (Ruth Kelly) As far as I understand it from my recollection

of the Baird Report, that was considered very near the end of

1998, just as the transfer of power was already taking place.

  105.  It says in the Baird Report, "The note" - from the

Treasury officials to Sir Howard - "contemplated closing

Equitable Life to new business" but it does not say what the

conclusions of that were.  One has to draw assumptions.  Would

that not have been a sensible course, given that this was a

company, even on the Treasury's own view, where there were

serious questions about its solvency?  How could the Treasury

and the FSA allow this company to go on trading for another two

years with new policy holders joining when it was considered

almost to be insolvent?

  (Ruth Kelly) You are asking me whether, within the six month

period after we became aware of the exposure to guaranteed

annuities, we should have made what I would consider a very

bold decision to close Equitable Life to new business on that

basis.  The need potentially for new capital had been

recognised.  The need to reserve in their entirety the

guaranteed annuities had been recognised and closing a life

insurance company to new business is not a costless option.

One way you might seek to transfer capital into a life

insurance company is to effect a sale of that company.

Closing a life insurance company to new business makes a sale

far more difficult than it might have been.  These are

regulatory and professional judgments.

  106.  If you joined a month after as a new Equitable Life

policy holder, not being in your existing lofty position, and

you thought you wanted to put some investment funds aside and

you discovered the Treasury was sending these reports out

considering closing it to new business, saying that the

information received to date about their reserves is

unconvincing and raises serious questions about its solvency,

and discussing whether it would have to effectively go out of

business, would you not feel pretty much aggrieved?

  (Ruth Kelly) It is not up to the regulator to give that sort

of financial advice to consumers.

  107.  The regulator should not be bothered about a company

that is about to become insolvent?

  (Ruth Kelly) Of course it should be bothered.  Precisely the

action through this period shows how concerned we were and the

action we were taking.

  108.  You did nothing until the House of Lords and Equitable

Life brought the whole thing to a conclusion.

  (Ruth Kelly) The requirement on the regulator is to ensure

that the life insurance company is being managed in a sound,

prudent fashion and to make sure that it meets its solvency

requirements.  As the note set out, that was the position.

  (Mr Cunliffe) If I could pick up the point about doing

nothing, throughout this period what the regulator was trying

to do was to get the company to increase its reserving and that

is what happened.  The regulator's response to the company

whose solvency was threatened was to try and improve that

solvency position.

  109.  When I say "do nothing", I mean that you did nothing

and the FSA did nothing for two years, to give advice to people

like potentially the Minister who might have been joining as

new policy holders that this was a company that was almost


  (Ruth Kelly) It is an extraordinary position that you are

suggesting, that we should in some sense, when a company goes

through a difficult period, advise people that they should not

be investing in it when the way through this is to try and

encourage the company to improve its solvency requirements.

  Mr Laws: It is not me who is saying it.  If you read the

Baird Report you will see criticisms of the fact that the FSA

did not pick up on the advertised information and did not take

any steps to ensure that new investors had any information

about this.

                           Mr Tyrie

  110.  You said a moment ago in response to the question

about gross regulatory failure that it would be open to policy

holders to sue the regulator.  As you well know, you must be

aware that the FSA is immune from judicial review, except in

cases of bad faith.  Indeed, against advice from many quarters,

the government pressed ahead with putting that on the statute

book when the Financial Services Bill went through the House.

Do you not realise, Minister, that the idea that redress may be

obtainable through the courts by policy holders who have lost

out against the regulator would be greeted with a hollow laugh

by them?

  (Ruth Kelly) The options remain open for people to pursue

this through the courts.

  111.  There are no options.

  (Ruth Kelly) I do not understand the position you are

putting forward to be the case pre N2 when all the formal

transfer of powers takes place at the end of November and

formal transfer of authority goes to the FSA but, to be

absolutely certain for the record, that is something we shall

come back to you on.

                         Mr Plaskitt

  112.  At the time you came to the service level agreement

with the FSA and handed over the supervisory and regulatory

role to them, uniquely amongst all the cases you passed over

there was a warning flag attached to the Equitable Life file.

At that time, did you give the FSA any advice as to what they

should do about that case, that company and that file?

  (Ruth Kelly) We no longer retain the information in-house or

the supporting documentation or advice that may have been there

at that time, so it is very difficult for me as Minister now to

form a view of the surrounding debate.  I am entirely reliant

upon what the Baird Report says and this is one reason why I

thought it important to set up the Penrose Inquiry, as Penrose

himself will be able to gain access to all the documents, not

just in the post 1 January 1999 period, but also in 1998 and

indeed going right back further into the history of the affair

and also to ask other key players such as Equitable Life

themselves how they related to the regulator over this period.

  113.  It was not that long ago.  Are you telling us that no

one in the Treasury can remember whether any advice was given

to the FSA as to what they should do about Equitable Life?

  (Ruth Kelly) All of the insurance regulators transferred to

the FSA at that time so we have no in-house expertise in this


  (Mr Fellgett) Shall I run through the way in which the

insurance supervision function moved?  This was the function of

a division within the DTI up to the first few days of 1998.  It

then transferred into the Treasury and it was essentially the

same people with the same knowledge and the same papers, doing

the same job, sitting in the same building, still the DTI

building in Victoria Street, not the Treasury building.  They

worked alongside my part of the Treasury for a period of a

year.  The function never came into my area.  It was a

continuing Treasury responsibility.  They are essentially the

same people, with the same papers, the same knowledge etc., who

moved to the FSA at the beginning of 1999 and indeed moved

offices to Canary Wharf.  As the Economic Secretary has

explained, the history does not lie in the Treasury; the

history, for very good reasons, lies in Canary Wharf.

  114.  There was a period when there was Treasury

responsibility.  What does "responsibility" mean?  How is that


  (Mr Fellgett) In this context, the responsibilities of any

department of state are set out in the Insurance Companies Act

of 1982, which was essentially to regulate in terms of the

solvency of the company and the fitness and properness of the


  115.  We ought to ask you questions about what you did while

you held that responsibility and yet, when I ask the question,

you have not got the files.

  (Ruth Kelly) It is s very difficult for us which is exactly

why I thought it was important for Penrose to have an

independent inquiry which covers this particular area and to

form his own conclusions on the basis of that.  No doubt in due

course you may want us back again to discuss those issues or

you may want to ask Lord Penrose what his assessment of that

period is.

  116.  We have not managed to discover what advice you handed

over when the FSA took over.  What about subsequent monitoring?

Once they had taken over and assumed responsibility, did you in

any respect monitor what they were doing with respect to

Equitable Life or did you cease to have any interest?

  (Ruth Kelly) There is a fairly clear mechanism of

accountability laid out for the FSA which was extensively

debated at the time that the Act was debated in Parliament.

One of the ways in which the Treasury gets involved with the

running of the FSA - "gets involved" is much too strong a term

- monitors what is going is they hold quarterly meetings on the

insurance side with the insurance regulators  to discuss issues

of significance.  In addition to that, there are extensive

bilateral meetings between both sides.

  117.  Can we take it that Equitable Life is on the agenda at

all of those meetings?

  (Ruth Kelly) I do not know whether it was on the agenda at

all of those meetings but it clearly featured in those


  118.  You were doing the monitoring.  Were you satisfied

that the FSA was doing all you expected it to do in relation to

Equitable Life?

  (Ruth Kelly) I think there is a real question of principle

here about what you consider the appropriate role of ministers

and the Treasury to be in the regulation of the insurance

industry and indeed in regulation per se, because what we made

clear at the time of the contracting out order, when the powers

were first contracted out to the FSA to do insurance regulation

on our behalf, was that we wanted to take advantage as quickly

as possible of the benefits of a single, independent regulator.

The judgment behind those decisions was that, in the long run,

it is actually better for a consistent approach to be taken

across different sectors and for this to be carried out by

professionals -- after all, regulatory judgments are clearly

professional judgments - rather than to be second guessed or

somehow managed by Treasury officials or ministers.  We set

that out very clearly in the debates at that time.  That was

the policy behind the transfer of powers and that also lay

behind the decision to transfer in its entirety the insurance

division within the Treasury to the FSA.  What you are

suggesting by your question is whether that was an appropriate

model to follow.  My answer is yes, I do think it is the

appropriate model to follow.  Of course there will be

particular instances in which we have a direct interest but in

the long run it is better that those regulatory issues are

dealt with by professionals with the appropriate expertise

rather than by ministers and Treasury officials.

  119.  Monitoring went a bit further than just receiving

reports back?

  (Ruth Kelly) That is right.  There was quite a lot of

discussion between the Treasury and the FSA but, in the end,

they are the ones who have to take the decisions and they are

the ones who have to be held accountable for the decisions

which they make.

                          Mr Ruffley

  120.  Minister, you have talked about the contracting out

but the Treasury are not quite off the hook, are they, post

January 1999 because you have a responsibility, do you not, for

monitoring the service level agreement?  One of the

requirements of the service level agreement that the FSA has to

discharge is to carry out the regulation of insurance companies

efficiently and effectively which is in schedule one.  Can you

really say to us today that you think this agreement with the

FSA has been adequately carried out in the light of the Baird

Report efficiently and effectively?

  (Ruth Kelly) It is very difficult to draw very distinct

lines in between one regime being in place and another regime

coming into being.  It is very difficult to say from one day to

the next that everything must change.  Clearly, regulation is

an evolving process where lessons are learned etc.  What was

clear to us in 1997 when we came to government was that what

was needed was a much more consistent and coherent approach to

regulation across the different sectors.  It is clear that

sectoral boundaries are much more blurred, for instance,

between the large insurance companies and between the large

banks and those sectoral boundaries no longer exist in the way

they used to.  What we needed was a new regulatory approach.  I

think what the Baird Report does very clearly is reinforce the

view not just for a consistent approach but for better

coordination between the different arms of the regulatory

system such as the conduct of business regulation of the PIA

and the prudential regulation of the industry which had been

carried out by the Treasury previously to that and by the DTI.

It reinforces that message.  Yes, we had set the system going,

we had set it off in the right direction.  It was taking time

to bring that into effect and, in the case of the Equitable,

Baird speaks for itself.  Had these benefits been realised

earlier ----

  121.  I am sorry to interrupt you, Minister, but that does

not relate to the question I asked.  It is a very simple

question.  The Treasury have to see that the FSA discharges the

agreement that the Treasury has with the FSA.  One of the

requirements on the FSA is to carry out the regulation of

insurance companies efficiently and effectively.  I am asking

you, as the Minister responsible for looking at and monitoring

that service level agreement over time: do you believe that the

FSA has carried out the regulation of insurance companies

efficiently and effectively having regard to the Baird Report?

It is a yes or it is a no.

  (Ruth Kelly) Baird speaks for itself.

  122.  Can you speak for yourself and give me a yes or no to

that very simple question?

  (Ruth Kelly) We no longer have that regulatory expertise,

but it is clear ----

  123.  You are the Minister responsible, with respect.

  (Ruth Kelly) Of course.  It is clear from the report that

decisions would not have been taken in the way that they were

and, with the benefit of hindsight, different decisions may

have been taken.  What is also clear is that the full benefits,

had they flowed earlier from the setting up of the single

integrated regulator, would have potentially benefited the

policy holders of Equitable Life.  That is something we are

absolutely determined to see now when formal transfer of powers

takes place and we have to ensure that those benefits are fully


  124.  As the Minister responsible, you have to ensure --

that is what Parliament charges you with doing; we have to

scrutinise what you are doing - that  the service level

agreement is adhered to.  Is that correct?

  (Ruth Kelly) My job ----

  125.  Is that correct?

  (Ruth Kelly) My job is to make sure that insurance

regulation is carried out in the best manner appropriate in the

best framework that we see fit and that the regulatory

judgments themselves are carried out by people ----

  126.  The service level agreement, with respect, does not

say that.  You have to police it and enforce it.  I think you

are conceding that which must be right, but has the carrying

out of the regulation of insurance companies been done

efficiently and effectively?  That is what you have to decide -

not anything else - as the Minister, whether or not that has

been discharged.  It says so in the agreement.

  (Ruth Kelly) Baird makes clear it could have been done

better and I do not think Howard Davies, when he was here

before you, suggested anything different.

  127.  It was not done efficiently and effectively?

  (Ruth Kelly) There are clearly lessons that can be learned.

  128.  The Parliamentary Ombudsman inquiry relates to post 1

January 1999 and to the closing of business in the following

December.  Would you welcome the Parliamentary Ombudsman

extending his inquiries to cover the period during the calendar

year 1998 when the Treasury was the prudential supervisor?

  (Ruth Kelly) I think it is totally inappropriate for me to

comment on the terms of reference and the course of the

direction ----

  129.  I asked if you would welcome it and the answer seems

to be no.

  (Ruth Kelly) I think it is important to preserve that


  130.  Do you think it would be a good thing?

  (Ruth Kelly) It is up to him and it is up to you to put

pressure on him if that is what you think.

                          Mr Cousins

  131.  Could I pursue some of the points we have just been

considering for the period after 1 January 1999?  The

government actuary in the Baird Report records two very

important letters that were sent out by the government actuary

to the actuaries of the life insurers after that date around

this issue of reserving.  This is after 1 January 1999.  One

letter I think is in January; another letter is in December.

Were ministers informed or made aware of those letters and

their significance?

  (Ruth Kelly) As I said before, the intention behind the

contracting out of the powers of the FSA was to have them act

in as independent a fashion as was possible at that time.

There are regular, bilateral discussions, some of which will

have been minuted, some of which will not have been minuted.

There are regular quarterly meetings.  It would be impossible

for me now to know exactly how those conversations developed

but whether that specific issue was drawn to the attention of

Treasury officials I have no evidence about in order to answer

the question.

  132.  But it is after 1 January 1999.

  (Ruth Kelly) That is right, so it is the FSA's business.

  133.  I would be grateful for more information on that

point.  Could I turn to one matter that was not contracted out

to the FSA under the service level agreement and that is the

approval of section 68 orders.  These were the orders that

enabled Equitable Life to draw into its accounts a projection

of future profits.  The section 68 order that was made in

September 2000 was after the result of the House of Lords case

in its entirety.  Were ministers informed of the issuing of

that section 68 order which enabled Equitable Life to put a sum

of over 1 billion of anticipated profits into its accounts?

  (Ruth Kelly) Under the contracting out order, it was not

possible to contract out section 68 orders so the Treasury had

to sign off.  However, in order to fully benefit from the new

approach and contract out as far as possible the day to day

regulation of the insurance industry and other industries, all

of the technical expertise lay with the FSA and we were wholly

dependent on the FSA for their judgment as to whether it was an

appropriate thing to do.  The Baird Report specifically raises

some issues as to how that was handled and whether there was a

full assessment of the issues when the section 68 order  was

presented to the Treasury.  I do not think it is unreasonable

to say that they are the ones with the professional expertise

and it would have been unreasonable for the Treasury not to

accept their professional judgment.  On the question whether

ministers were informed, I have no evidence that they were ever

told about that.  I do not think so.

  134.  You do not think so?

  (Mr Fellgett) In that period, there were very many section

68 orders for many insurance companies.  It is a regular

process under which the regulators decided it would be right to

provide this agreement to present their figures in a particular

way.  My understanding is it is done regularly for many

insurance companies, not just the Equitable.  To the best of my

knowledge, that was not something brought to the attention of

ministers because, as the Economic Secretary has said, it was

treated as something on which we should rely on the FSA's

advice as the people who were the professionals and who could

look at the picture in the round as to whether or not this was


  135.  How many section 68 orders were there for the year


  (Mr Fellgett) I believe there are at least dozens.  If you

would like me to find the precise figure it may be higher.  I

do not mean in relation to Equitable; I mean this is a normal

part of the process under which the regulators ----

  136.  This is all the section 68 orders that were not

contracted out and that were still a Treasury responsibility.

  (Mr Fellgett) We will find you a figure if you wish.

  137.  Yes.  In the case of the section 68 order which was

given on, Baird tells us, 11 September 2000 without the

relevant committee even meeting, which is fairly remarkable,

this is after the House of Lords judgment.  Ministers were not

informed and your attitude to that would be that it is a purely

routine thing?

  (Ruth Kelly) My attitude to that is that it was a purely

routine thing.  Whether it should be a purely routine thing is

a completely separate question.  I am sure it is one that the

FSA itself will be considering and I am sure it is one that

Lord Penrose himself may have views on.

  138.  All of this peculiar period in which the FSA inherits

the powers of its predecessor for conduct of business it has

contracted out to it the Treasury's role for prudential

regulation and this period has gone on now for well over 18

months.  This will be a period of transition of almost two

years.  Do you think that the postponement of the date for full

operation of the new Financial Services and Markets Act has had

a very woeful effect on the outcome of this affair?

  (Ruth Kelly) On the postponement of N2 at the end of


  139.  Yes.

  (Ruth Kelly) As far as I understand it, that was a date

which was as early as considered absolutely, technical feasible

by those in the industry and by the FSA.  That has imposed huge

pressures on members of the Treasury in order to gain those

advantages as quickly as possible.

  (Mr Cunliffe) The objective behind the contracting out order

was to bring those benefits of the full establishment of the

FSA in as quickly as possible.  What I saw in the Baird Report

was that the FSA was trying to get those benefits linking up

prudential conduct of business and looking at large insurance

groups as part of an overall question of risk in the financial

sector.  Notwithstanding the fact that N2 had not gone through,

the FSA was acting as if it was the single regulator.  I have

not seen anything in here which suggested a confusion on the

FSA's part as to where the final responsibility lay.  That is a

confusion that you will not have after N2 because the position

will be clearer, but that contributed.  It is a question you

would also have to ask Howard Davies but I think the FSA was

asked to bring the regulation of insurance companies into its

unitary structure as soon as possible from day one and that is

what they tried to do.  I am not sure that, had they gone

through N2, it would have been any different.

  140.  Not having gone through N2, the formal responsibility

for prudential regulation still rests with the Treasury.

  (Mr Cunliffe) Yes.

  141.  That was obviously a substantial difference.  Do you

not think, looking at the Baird Report,  that at various points

during 1999 there is a real tension inside the FSA between its

role as a prudential regulator wanting to keep the institution

going, wanting to see if it could trade out of the position

which it was in, and its role as a conduct of business

regulator, trying to advise people who were writing to it,

complaining to it about a number of aspects of the Equitable's

behaviour in that period?  Would you agree that there was that


  (Ruth Kelly) What the Baird Report shows clearly is that if

there was a tension there should not really have been.  The two

arms of the regulator needed to take a coherent approach to the

problem and if they had done so, they might have spotted

earlier the problems which later emerged.  The prudential

regulator is much more intimately involved with the company, as

you rightly say.  It has its solvency under close scrutiny at

all times; whereas the conduct of business regulator takes a

much more stand off approach than it has done in the past and

has relied upon people coming to it with complaints.  My

reading of the report was that not many people did that,

particularly in certain critical periods.  One of the

rationales behind the creation of the integrated regulator is

not just to provide a consistent approach but to introduce a

much more risk based approach which will concentrate resources

appropriately on key issues, particularly the conduct of

business ones which emerged in the actual case which were not

subject to that risk based regime.

  142.  If there was a failure of the FSA as a conduct of

business regulator, where would the ultimate legal and

financial responsibility of that lie?

  (Ruth Kelly) As far as I understand it, the position is that

the PIA is still currently a self-regulatory organisation and

will remain so for the formal transfer of powers at the end of

November, despite the fact that its employees are employed by

the FSA and the FSA is responsible for monitoring how it

complies with the rules.  It is a very odd situation but the

PIA would be responsible.  What I read from the report is that

they did fail to operate in a coherent fashion and that it is

essential from now on that these two sides of the regulator

liaise in a much more coherent way over particular companies

and particular issues.

  143.  You do consider the possibility that there was conduct

of business regulation failure and, if there was, under the

terms of the old Financial Services Act 1986, the

responsibility for burying the dead of that particular episode

would lie with the life insurance industry itself?

  (Ruth Kelly) I am not saying I think there was a regulation

failure on the conduct of business side.  I am saying that

Baird very clearly shows that there should have been a more

consistent and coherent approach to these issues.  I am

determined to see that that now happens, which is precisely why

I have been pressing the FSA on this point.  As I understand

it, you are right.  If there were evidence of failure, it would

rest with the PIA and then it would be the industry which would

be responsible.

                        Kali Mountford

  144.  Policy holders who are making decisions about their

financial future do the best they can with the information they

have available to them.  In this instance, they found that

their reasonable expectations had been built on sand and in the

Myners Report there is severe criticism of how transparent the

industry is.  If there had been a better definition of PRE, do

you think that the Equitable Life episode could have been

discovered earlier?

  (Ruth Kelly) It is a really interesting question.  The

nebulous nature of policy holders' reasonable expectations has

been a recurrent issue throughout regulation.  It is something

to which the Baird Report clearly suggests more attention could

have been paid over the years for which the FSA was

responsible.  As I understand it, that concept is going to

change when the formal transfer of powers is handed over to one

of fair treatment for consumers.  The FSA is going to be

devoting its efforts to establishing precisely how that can

work in the best interests of consumers but policy holders'

reasonable expectations have been an issue which has bedevilled

the industry for a long time.

  145.  While pursuing a similar line of inquiry with Sir

Howard, I asked him if the concept had had its day and he

agreed it had, with only a month to live.  That leaves me with

some concerns about existing policy holders not just for

Equitable Life but across the insurance sector altogether,

given that policy holders still have what they believe are

their legitimate reasonable expectations from their policies.

Would it be useful at this stage, even now, to properly define

their reasonable expectations and have some sort of definition

that has a legal bearing?

  (Ruth Kelly) What we run the risk of doing is precisely one

of the accusations that has been mounted against the issue of

insurance guidance to insurance companies and that is to try to

second guess how a court might interpret policy holders'

reasonable expectations.  There is a real danger of doing that

and then the industry and the policy holders place too much

weight on how the regulator, which would be the FSA, interprets

those issues.  That is now a matter for the FSA to look at

before the end of November.  It is probably not the appropriate

time to be devoting a lot of its resources to understanding the

new concept of fair treatment of consumers.

  146.  I understood completely what both you and Sir Howard

said about fair treatment but what I do not see is the

transition between one set of concepts and the other and how

consumers can have some understanding of what their legal

position is, what their consumer rights are in this situation

and what applies for them, given that they have policies that

they have taken out under one set of suppositions and now they

are looking into a whole new future.  What protection is there

for them?

  (Ruth Kelly) In some respects, that is precisely why the

test cases were mounted in Equitable Life's case, to try and

understand how a court might interpret policy holders'

reasonable expectations and whether Equitable Life's practice

was consistent with that interpretation.  As it turned out, the

House of Lords decided that it was not.  Clearly others in the

industry will have been following that interpretation closely

but I do not think there is a very strong case for use of the

regulator now to be advising on how that test case might apply

to other parts of the industry, although clearly that is

something that you should be putting to Howard Davies.

                           Mr Beard

  147.  The only reason that anyone would have a motive for a

guaranteed annuity arrangement would be to protect themselves

against the position where the interest rate went down at some

point in the future so that they had a certain base for their

expectations of a pension.  That is the basis upon which these

policy holders that we are talking about were asked to invest

and yet, at the time when the interest rate did fall and they

were in need of this sort of guarantee, it was removed from

them in such a way that this terminal bonus arrangement left

them in no better position than someone who had not opted for

this to begin with.  It must be plain that that is not a

reasonable expectation of a policy holder.  It is a situation

almost amounting to fraud or deception.

  (Ruth Kelly) The interpretation which the House of Lords put

on it was that it was not consistent with policy holders'

reasonable expectations.  There were other views prevalent at

that time and other legal opinions, including that sought by

Equitable Life itself, which couched these issues in much more

vague terms than were subsequently arrived at by the House of

Lords.  There were different attitudes as to how consistent

that policy practice would be for policy holders.

  148.  It seems to me it is worse than that because the last

time we had a session on Equitable, when we raised this sort of

question, we were told this practice was common throughout the

life insurance industry.

  (Ruth Kelly) As far as we understand it, Equitable is rather

unique in that it neither imposed an explicit charge for its

premiums, nor built up any concrete fund to fund those

guarantees.  As I understand it, it was fairly unique, if not

unique in the industry, for acting as it did.  Other options

were pursued by different insurance companies when these issues

first emerged in the late 1980s.

  149.  The government actuary said to us that the process of

virtually abrogating GAA and putting it into a terminal bonus

was prevalent throughout the industry.  In addition to that, we

have the rest of the Baird Report that tells us about an

appointed actuary also acting as a chief executive.  We have

the whole question about the adequacy of reserves.  We have the

question of different figures given to the regulator compared

with the figures put into the accounts and then we have this

strange reinsurance policy added in.  This is on behalf of

Equitable, a company which was the oldest life insurance

company and the gold standard of the life insurance sector.

Does it not make you worried about what is going on in all

these other cases if that is the best one behaving in this sort

of way?  Should not the Penrose Inquiry really be investigating

the life insurance sector beyond Equitable, not just the issues

arising from Equitable?  There is a tendency - and there has

been this morning - for us to be pursuing the regulators but

they are a decoy.  These are the people that we ought to be

pursuing in the inquiry.  Can you assure us that the Penrose

Inquiry will indeed be pursuing this type of question right

through the life insurance sector, not just with Equitable?

  (Ruth Kelly) I think there are two responses to that.  The

first is I thought it important that the lessons of Equitable

be learned and to see what lessons could be learned from that

particular experience for the whole of the life insurance

industry.  His terms of reference are clearly set out to enable

him to pursue his agenda and I very much hope that he will

interpret that to the full.  Alongside that, there is a

separate study being conducted by Ron Sandler which looks at

the incentives behind the long term retail savings industry,

which will also be able to consider some of these largely

fundamental questions for the life insurance industry.

  150.  The other danger is that the Baird Report and other

means have revealed quite a lot already which implies that

there is something rotten in the state of Denmark.  Are we to

wait until the Penrose Inquiry has reported before any of those

issues are tackled or can we expect those issues to be tackled

in the meantime, despite waiting for Penrose?

  (Ruth Kelly) Not only can we expect them to be tackled; I am

absolutely determined to see that they are tackled, which is

precisely why, on publishing the report, I wrote to Howard

Davies asking him to report back to the Treasury on the actions

which had been taken to implement those lessons and

recommendations by 20 November.  I am expecting a fairly

substantive document outlining how the FSA intends to take that

forward.  What Penrose cannot do and what I cannot suggest is

that the Penrose Inquiry will somehow be bound by the

conclusions which emanate from this report.  Penrose has a much

wider remit.  He is able to look back at history; he is able to

look at other key participants; he is able to look across the

market place at prevailing practice.  He wrote to me to say

that he cannot feel bound by the conclusions of the report.

However, he accepts, I accept and the FSA accepts that it is

important for them to make progress immediately, particularly

on aspects which involve consultation with the market place,

for instance, and reviews of their activities, to start that

work immediately and for the Penrose review to feed into that,

to try and gain the best of both worlds.

                          Mr Fallon

  151.  Could I declare an interest as an Equitable Life

policy holder?  Why did the Chancellor tell this Committee in

March that there should not be an inquiry until the Baird

Report had come out?

  (Ruth Kelly) I have not seen the proceedings of that

Committee.  The nature of the problem has changed significantly

over the latest period.  The reasoning behind the launching of

the Baird Report in December 2000 was that the FSA should learn

immediate lessons for the way it conducted its own stewardship

of the Equitable Life and the industry over its period; that it

should learn the lessons as it set up its own structure before

the formal transfer of powers.  On top of that, it became very

clear to me over the summer that policy holder concern and

concern from Parliament and indeed the Treasury Select

Committee itself was very great on these issues; that the

issues were not something that we could in any sense choose to

ignore; that there might be wider implications for the industry

and that the issues themselves on their merits deserved a full,

independent inquiry.  That is why I decided to go down that


  152.  Originally, the Treasury's position was that an

independent inquiry might prejudice the policy holders'

decisions on the compromise deal.

  (Ruth Kelly) Once it became clear to me that an independent

inquiry was to be launched or should be launched, I had a

choice as to whether to await the Baird Report, which was at

some time undefined, and to announce an independent inquiry as

a response to Baird or to act quickly and to set up the

independent inquiry as soon as it was practicable to do so.  I

had a balance of issues to consider when making that judgment.

One, as is very clear, is the speed with which Lord Penrose

could get down to the work and the speed at which the report

could finally be completed and the lessons learned  both for

Equitable Life itself and the rest of the industry.  Another

issue which was quite high on my agenda at that time was a

desire to totally separate this independent report, as far as

possible, from very delicate decisions which are being taken by

Equitable Life policy holders as we speak.  They are in the

process of considering the compromise offer.  I wanted to make

absolutely clear, first of all, that I did not see this inquiry

as in any way relating to the issues on the table of the

compromise deal and therefore the earlier the announcement the

better.  Secondly, to use the opportunity to say very clearly -

- and not to mislead people - that I did not see at that time a

role for public money to support in any sense a lifeboat for

the Equitable Life Society, as I was being counselled that that

was a view that was currently being held by certain policy

holders.  I used the opportunity to do both things, to separate

the announcement of the inquiry from the compromise deal and to

set straight the record on the Treasury view of an injection of

public money.

  153.  Returning for a moment to the section 68 order and the

solvency for which you had responsibility, the section 68 order

on 11 September that rejigged the Equitable balance sheet to

the tune of 1.1 billion, was the Treasury aware that that order

was passed on the advice of the government actuary's department

that pre-dated the House of Lords decision?

  (Ruth Kelly) I do not think this was ever brought to the

attention of ministers and we relied very heavily on the advice

of the FSA for these orders.  It is clear from Baird that a

full assessment in the round was not presented together with

the section 68 order.

  154.  The answer is yes; you were not aware.  Is that right?

  (Ruth Kelly) I do not think we were given the full picture

of events.

  155.  You were not aware that the advice was flawed because

it was the advice of your own department, the government

actuary's department, given before the judgment that was relied

on of 11 September?

  (Ruth Kelly) As far as I understand it, the FSA presented

this to the Treasury as a routine regulatory issue, together

with their advice that it should be granted.

  156.  Can I ask you to comment on Sir Howard's admission

this morning that there were management failures?  You defended

the single regulator structure.  Do you agree that there were

management failures at the FSA?

  (Ruth Kelly) Baird clearly shows that things could have been

done in a different way.

  157.  Do you agree?

  (Ruth Kelly) This report was never intended to lay the blame

at any particular person's or institution's door.  That is

clearly set out at the beginning of the report.  It is clearly

written with the benefit of hindsight and the lessons which it

draws are based on that assessment.  Having said that, I do

think there are issues which come out in this report which are

of public interest and which Lord Penrose himself will want to

take into account in his report.  If anything, I think this

report shows that a single regulator is the way forward, that

what we want to do is to see the benefits flow as quickly as

possible from the joint approach.

  158.  The single regulator has admitted to management

failure.  Do you agree with that?

  (Ruth Kelly) I did not actually hear the earlier hearing.

  159.  Do you think there has been management failure or not?

  (Ruth Kelly) The report itself says, although I stand to be

corrected, that senior management could have taken a closer

interest in some of these issues.  To that extent, with the

benefit of hindsight, it is clear that it would have been very

helpful had senior personnel of the FSA taken a closer interest

in events earlier.

  Chairman: Following Mr Fallon's statement about declaring an

interest, a number of us discussed that earlier this morning

and, given that we were looking at Equitable Life itself rather

than legislation I ought to declare that I have an interest and

maybe some other Members have.

  Mr Ruffley: I have.

  Mr Plaskitt: I have.

                          Dr Palmer

  160.  I too.  Why was no target date set for Lord Penrose to

report?  There are an awful lot of people out there who are

very anxious to get a result quickly.

  (Ruth Kelly) Lord Penrose is probably the single most

appropriate person to conduct this inquiry in that he is a very

senior commercial judge but he is also an accountant by a

previous profession.  He is eminently qualified to carry out

this inquiry.  What he made clear to us in accepting his

responsibilities was that he first of all wanted to familiarise

himself with all of the particular issues surround Equitable

Life; that he was not in a position to say exactly how he

thought his inquiry would proceed, what evidence he would need

to see etc., but he still had to become familiar with all of

the issues involved.  I thought, under those circumstances, it

was better for him just to get stuck in and to make progress as

quickly as possible.  I remain of the view that he is an

incredibly determined man who wants to get on top of this as

quickly as possible and to report back to us as soon as he is

able to.

  161.  Do you think it is possible that he might not even be

able to report back during this Parliament?  The BCCI

investigation has been going on for ten years, I believe.

  (Ruth Kelly) I am absolutely sure that what he wants to do

is to make progress as quickly as he can.  It would be

ridiculous however for me to speculate on how his inquiry is

going.  I have no day to day contact with him and it is up to

him what courses of action he chooses to pursue.  Clearly, the

routes which he chooses to go down will very much determine how

quickly he reports, but that will be up to him.

  162.  I do understand that we have to leave it to him but

can you express an opinion from your position on whether it

would be welcome in the interests of the large number of people

out there who are waiting for the results if he were able to

complete his investigation within this Parliament?

  (Ruth Kelly) I think Lord Penrose understands the urgency of

this inquiry and is determined to get on top of the issues as

quickly as he can.

                           Mr Laws

  163.  Would you be disappointed if we did not have a report

from Lord Penrose by the end of next year?

  (Ruth Kelly) I think it is unlikely that we will not have a

report, given his determination to pursue the issues.

  Chairman: Can I thank you very much, Minister?  You have not

experienced this side of the counter before as a Treasury

Committee Member.  I hope the experience the other side was

novel for you.  Can we thank you and your officials for your

attendance this morning?