Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 645 - 659)



  Q645  Chairman: Minister, welcome to the session this morning. Apologies for the delay but the session with Lord Penrose was very interesting. Could I start with general questions about the timing of the inquiry. As you know, many people had hoped that the inquiry would be completed, and a report published, long before now. Why did you feel able to tell the House in October 2001 that you expected Lord Penrose to have reported before the end of 2002?

  Ruth Kelly: Clearly in the run-up to setting up the inquiry, at the end of August 2001, we approached Lord Penrose to see if he would be willing to accept the task; and at that time I had a discussion with him as to how long he thought it would take him to complete his enquiries. After all, it was an independent inquiry, a judicial inquiry, and it was only right that he should conduct it in a way that he saw fit. Together we thought that would be the approximate timescale for him to complete his enquiries. In the event, as he informed the select Committee during the proceedings, it took rather longer than he anticipated at the time.

  Q646  Chairman: You received the Penrose report in December, and indicated earlier in January that you intended to publish it in full. Why has it taken so long for you to publish it? Could you clarify exactly what further examination was required before the final decision on full publication was taken? What might have required you to keep certain parts confidential?

  Ruth Kelly: As you will understand and as all members of the Committee will understand, it is a huge report going back over 30 years; it covers incredibly complex legal and actuarial issues. It clearly took us time, not only to read the report and obtain legal advice on whether any privilege obtained to its contents, so that we could waive legal privilege to disclose in the public interest, but also I think what Lord Penrose found in his report, which is very important to consider for both current policy holders and past policy holders, is as he puts it a "persistent and deep-rooted problem" within the Society itself that led to the over-allocation of bonuses over a prolonged and sustained period amounting to, he estimates, around £3 billion. Clearly this information itself, which Lord Penrose has put out in the public domain through his report, could have implications for policy holders, and thereby could have implications for the Society itself. It was only right, I thought, to take proper, prudent precautions using due diligence to check the material and the facts relating to the Society, both with the FSA and through the FSA with the Society to make sure that we could assess their impact on the Society, for publication. It was also right that the FSA had an opportunity to look at whether there were any wider systemic implications of the material in Lord Penrose's report before publication, and assured us that they did not think there were systemic implications and that we could proceed to publish.

  Q647  Chairman: Are you now in a position to clarify which elements in the report are the subject of investigation by the SFO? When do you expect the SFO to complete its investigation?

  Ruth Kelly: Lord Penrose himself delivered his report to the SFO after he had completed it. He also tells me that he showed extracts of the report as he proceeded to write the report; and on the way he showed them to the SFO. We followed up that by passing extracts of the report, which we thought might be relevant, to the SFO for them to look at. It is clearly not for me to comment on where the SFO is with their investigations, other than to say on the day of publication of the report the SFO did put out a press release, which I have seen and indeed have here, and they say that, "No decision has yet been made to commence an investigation under section 1 of the Criminal Justice Act 1987. The SFO is still considering the issues raised and, in particular, whether the adoption of a differential terminal bonus policy was communicated to policyholders and prospective policy holders".

  Q648  Angela Eagle: It is an extraordinary story to see what happened in the Society as shown by Lord Penrose, which surely must have some lessons. We had a Society where certain leading members of it decided to behave in this way and dissipated entirely the Society's reserves in going for growth and pursuing business. It almost became like a pyramid scheme over time. We had a board that, in Lord Penrose's words, at no stage fully got to grips with the financial situation, which was too fragmented, had collective skills which were inadequate for the task, no effective arrangements for ensuring that there was detailed examination, or none that were reported to the Board. We then had policyholders not being told about this approach to fund management which was "fairly novel", let us put it that way, and almost like being a bank without having any reserves. Policyholders were not told, between 1983 and 1986, that this approach to asset management had been adopted. This was and is a mutual society. Could this have happened if there had been shareholders rather than policyholders? What implications are there for regulation of mutuals in order to prevent this extraordinary state of affairs from developing again?

  Ruth Kelly: You make a number of points there, many of which are intrinsic to the argument that Lord Penrose himself presents. First of all, he is absolutely clear that the management was going headlong in pursuit of growth, and he said they approached growth with almost a "missionary zeal" to quote directly from the report. He also identifies the fact that the board itself, as you rightly put it, at no stage got fully to grips with the information presented to them; but he also says full information about the risks to the business were not presented to the board; and identifies how policyholders were not told until 1996 what was going on in relation to the terminal bonus policy, even though (he says) the executive management had formulated this strategy internally as early as 1983. The issue about mutuals I think is an open question. It is very difficult for me   to know what would happen in similar circumstances in a different company. What I can do is look at the report and say that clearly Lord Penrose points to how the governance of mutuals could be improved; and points to corporate governance failure that we intend to address through our review of mutuals. I certainly think it is the case that people expect mutual life offices to be as accountable to their members as comparable companies are to shareholders. Through the review that is what we hope to achieve.

  Q649  Angela Eagle: Do you think there are any systemic worries about allowing the situation where somebody is the chief actuarial officer and then becomes the chief executive as well and becomes, in Lord Penrose's words, "unassailable" once he has got those two positions? Do you think there is an argument for preventing both of those duties being held by the same person?

  Ruth Kelly: I think there is a clear conflict of interest, and it is one of the issues that the FSA has recently been addressing through its consultation paper on reform of the appointed actuary system. Under the previous regime, which was called by those in the industry "freedom with disclosure", a huge amount of emphasis was placed on the appointed actuary both to represent the interest of the policyholder on the board, and then to liaise with the regulator about what was happening to the reasonable expectations of policyholders. Clearly when the appointed actuary is also the chief executive of the company those interests do not necessarily coincide and there could be a conflict. The FSA has recently decided to remove the responsibility from the appointed actuary monitoring whether customers are treated fairly and place that firmly on the entirety of the board which now has to take those issues seriously. I think that is exactly the right way forward.

  Q650  Angela Eagle: There is always a balance to be struck between regulation that is over-burdensome and regulation which actually does the job it sets out to do. Most of the problems with Equitable began in an era of extremely lax paper-based regulation, which clearly did not keep up with the vast changing realities of what is an extremely complex and "opaque" industry. What lessons do you think need to be learned, and what is the Government doing to learn lessons about the so-called "light touch" regulation which happened in the 1980s and early 1990s? What lessons has this Government learned about that, and what are you, as the Minister responsible, doing?

  Ruth Kelly: I think if you follow through the train of Lord Penrose's arguments he says that back in 1973 with the Insurance Companies Act a reactive paper-based approach was set up to monitor insolvency of insurance companies. He said there was a deliberate policy, designed by ministers, and there were instructions from ministers that it should be reactive and paper-based. He says, "Fair enough", [this is how I read his report] that might have been okay at the time, because practices could be ascertained from paper-based regulatory returns but as time  progressed, as the industry became more sophisticated, as companies moved gradually towards using discretionary terminal bonuses as a   way of remunerating policyholders and, in particular, Equitable shifted towards the use of discretionary non-guaranteed terminal bonuses, then that was the time when the regulator and ministers in charge of the policy should have sat up and taken notice and updated the regulatory system to become more risk-based, more proactive, and actually up-skilled and upgraded the resources devoted to insurance regulation as well. He points out that in the early 1990s there was in fact a debate going on in Europe about the appropriate way to monitor and look at the financial position of insurance companies and how to regulate them.

  Q651  Angela Eagle: The Third Life Directive?

  Ruth Kelly: Yes. That debate went on for four years. There was a very strong and compelling case put forward that the approach should be a more cautious one than the one adopted by the United Kingdom but ministers determined against that policy. They watered-down the proposal coming from Brussels, and continued the process as it was on a paper-based reactive system, which was not set up   to, and could not, monitor policyholders' reasonable expectations. He thinks there was a clear lesson that that system should have been updated at   that time to take account of the increasing complexity of the life assurance industry. He says the key message from his report is regulation, and it should be updated to reflect the requirements of a   changing industry. Of course, when this Government came in, in 1997, it took immediate action to set up the Financial Services Authority—a move which Lord Penrose himself says reflects the comprehensive reassessment of the requirements of an efficient regulatory system; but the lesson we take from his report is that it is not enough just to sit back and let the regulatory system remain in its state. If there is a need for continuous improvement the FSA is always consulting on reforms. We are currently going through a process of moving over to realistic accounting, a twin-peaks approach to regulating insurance companies. From this report we have now set up a review into mutual life offices and the actuaries profession, and we have asked the Accounting Standards Board to look at whether there is sufficient reserving for terminal bonus in the system. I think we have to continually be on our toes and make sure that the regulatory system is kept up-to-date. We accept his recommendation on that.

  Q652  Chairman: On the responsibility of Equitable Life, Minister, you have suggested that the main recourse for those seeking compensation should be with the Financial Ombudsman Service, but any   compensation awarded by the Financial Ombudsman Service will simply come out of Equitable's with-profits funds, cutting policy values still further. Is that an effective solution to policyholders' problems?

  Ruth Kelly: Lord Penrose raises the huge potential issue of over-bonusing taking place over at least ten years or so. He estimates that it amounted to around £3 billion, estimates which he says are necessarily crude. The company itself, when presented with the figures, refutes the allegation that any over-bonusing, if it did indeed arise, would necessarily lead to future claims. Clearly there is a stand-off in the position between the account presented by Lord Penrose and the position taken by the company. The company maintains very strongly that it was not the history of over-bonusing that led to the sharp 16% cut in July 2001. In fact the 16% cut predominantly reflected market conditions as well as a variety of other factors. It is a very complex actuarial issue that could ultimately only be decided by the courts.

  Q653  Chairman: You will know from our report last week on endowment mortgages of the artificial time limits that have been imposed on people to claim, and that is three years in the case of endowment mortgages, and we are looking for some action on that. The Equitable saga has dragged on for so long there is a real danger that many policyholders will now find themselves time-barred from the Financial Ombudsman Service. Have you any plans to have discussions about modifying the time limits to claim compensation in the case of Equitable?

  Ruth Kelly: I have had a discussion with the Financial Ombudsman. I have offered any support and resources that he needs to deal with any complaints that flow from the Penrose Report. The Ombudsman, at this moment in time, assures me that he has all the resources he thinks is sufficient to deal with any complaints, and he did not raise a particular issue about time limits.

  Q654  Chairman: I think the time-barred element is important, certainly for endowments and here as well. I wonder if you could keep that in mind, Minister?

  Ruth Kelly: I certainly will. Officials will no doubt correct me if I am wrong, but I think when new information comes to light that policyholders are able to present complaints to the Ombudsman. Clearly in the case of the Penrose Report, that information has just been put into the public domain.

  Mr Wynn Owen: That may well help with the situation. It may be that the clock starts ticking again from the publication of the Penrose Report, though obviously the Financial Ombudsman would need to take legal advice on each specific case.

  Q655  Norman Lamb: In terms of the responsibilities of the Government, you said in your statement, ". . . Lord Penrose makes no recommendation for the payment of compensation . . . ". You also said, "Nor does he conclude economic loss was caused to policyholders by the regulatory system". The inference there is that compensation, according to Lord Penrose, should not flow from any regulatory failures. Is that what you were saying?

  Ruth Kelly: No, what I said was Lord Penrose did not consider the issue of compensation. He made no recommendation on compensation. He specifically said in his report that he was not attempting to allocate blame; that policyholders should not base any expectations on the findings of his report; and he also says that principally the Society itself was the author of its own misfortunes.

  Q656  Norman Lamb: He also refers to regulatory failures being secondary to that, and he accepted that that is almost self-evidently the case that regulatory failures follow a problem with the host organisation. You referred to the fact there was no finding of maladministration, but you accept that this was simply not part of his remit?

  Ruth Kelly: I think if you check the quotes it says "regulatory system failures were secondary factors", and not "regulatory failures were secondary factors". He also goes on to say and is very clear on this point, and I have got the quotes in front of me, that it was the system that failed to provide the regulation that changing circumstances in the industry required, not that there was a failure to implement what was fundamentally a satisfactory system. He also says, "I do not pin the blame on individuals, who in the main have operated in good faith and to the best of their abilities within the system as they found it". He makes certain comments about the system, that it was under-resourced, that it was a reactive paper-based approach in the 1980s and early 1990s.

  Q657  Norman Lamb: Criticisms of it, not just comments.

  Ruth Kelly: Absolutely, criticisms of the regulatory system. He says, "I do believe the regulatory system failed policyholders in this case". With hindsight, that is certainly something we accept. In fact, we argued for a change in approach and, as soon as we came in, in 1997 we started setting up the Financial Services Authority.

  Q658  Norman Lamb: You quoted in your statement something from Lord Penrose in paragraph 84 of chapter 20: "The deficiencies are not so obvious as some are inclined . . . to believe. And . . . it is not enough in this case, to infer from the coincidence of systems deficiencies and loss that one caused or contributed to the other". Lord Penrose very clearly in his evidence this morning said that, although you cannot infer it, he was not ruling it out. It was simply not an issue that he considered as part of his report. Do you accept that, that there could be a connection between loss suffered and regulatory failure, but it was simply not something he covered in his report?

  Ruth Kelly: I would make a number of points. The first is that he had full benefit of hindsight. The second is that he specifically did not pin any blame on individuals. The third is, and in the comment you raised, he was talking about system deficiencies and not the deficiencies of individuals. The fourth is he makes no recommendation for compensation whatsoever.

  Q659  Norman Lamb: Do you accept that he does not rule it out?

  Ruth Kelly: No, I am putting to you what Lord Penrose has said, but I also am putting it to you that we found, with our own analysis as well, no evidence whatsoever of any maladministration.

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