Examination of Witnesses (Questions 645
TUESDAY 16 MARCH 2004
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
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
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
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
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,
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
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 Authoritya 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
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
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
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.