TUESDAY 30 OCTOBER 2001 __________ 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. Chairman 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 Services. 87. Thank you very much. Did the Treasury in any way attempt to modify or change the Baird Report before it was published? (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 Inquiry? (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 carefully. 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 affair. 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 œ49.50 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 directly? (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 inquiry? (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 guarantees. 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 insolvent. (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 area. (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 defined? (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 management. 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 meetings. 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 developed. 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 independence. 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 œ1 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 2000? (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 November? 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 tension? (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 route. 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?